Only a taxpayer selling a “capital asset” may realize capital gain income on the sale of property and benefit from the lower tax rate that applies to this income. Also, the taxpayer must have held the capital asset for more than one year. Only property or a property right can be treated as a capital asset. The right to a stream of income is not considered to be property for this purpose. Certain things that are not obviously property may sometimes be considered property for tax purposes, as seen in the recent case of Long v. Commissioner (CA 11, November 20, 2014). InLong, the United States Court of Appeals for the Eleventh Circuit reversed a prior decision of the Tax Court and allowed capital treatment for a taxpayer who had essentially sold a contract right.
In 2002, the taxpayer entered into a contract to purchase real property in order to construct a condominium building and then sell the condominium units. In 2004, before the sale had been completed, the seller defaulted on the contract. The taxpayer sued the seller and obtained a judgment, which the seller appealed. While the appeal was pending, the taxpayer sold his position in the contract, including the judgment, to a third party for $5.75 million, representing a substantial gain.
The IRS determined, and the Tax Court held, that this was ordinary income. The court’s rationale was that the taxpayer would have developed and sold condominium units if he had been able to purchase the real property. Property held by a taxpayer for sale in the ordinary course of his business is not a capital asset. In effect, the court characterized the taxpayer’s rights under the contract based on his intent to develop and sell interests in the land that he had attempted to purchase.
The Eleventh Circuit reversed the Tax Court and held that the taxpayer was entitled to long-term capital gain treatment. The Court of Appeals determined that the asset sold was the contract itself, including the judgment the taxpayer had obtained on that contract. The character of this asset could not be determined with reference to what the taxpayer would have done with the land itself. The court determined that the taxpayer did not acquire the contract or the judgment with the prior intent of selling either. Therefore, his contractual right to purchase the land was itself a capital asset and his gain arising on the sale of the contract was subject to tax at the lower capital gain rate.
This case may also be beneficial for other taxpayers who sell their interests in court judgments, a practice which has become fairly common. Where litigation is based on rights arising under a contract for the purchase or sale of property, the Long case may serve as authority for capital gain treatment, at least in the Eleventh Circuit. However, the IRS is not likely to concede this issue and the Tax Court does not have to follow the precedent of the Eleventh Circuit in any future case that would be appealable to a different circuit.