In Tempel, the taxpayers sold a portion of their newly received transferable Colorado state income tax credits, i.e., in the aggregate sum of $260,000, that resulted from a donation of a conservation easement on approximately 54 acres of the petitioners' land in Colorado.
In reporting two transactions in which the taxpayers subsequently sold $110,000 of their credits to separate unrelated buyers, the taxpayers claimed a cost basis in the tax credits equal in amount to an allocable portion of the professional fees incurred to make the donation. Also included was an allocable portion of land basis, on the rationale that the credits in substance constituted a separate property right that was part of the land.
The IRS, after reviewing the returns whereby the taxpayers reported the gain as short term capital gain after reducing the amount realized from the “costs” allocated to the credits, challenged both the basis computation and the character of the gain reported.
The Tax Court, per the opinion of Judge Wherry, rejected the taxpayers calculation of basis. First on the basis that the taxpayers did not “purchase” the credits. Next, their basis in the credits did not include a portion of their basis in the land. The credits were instead separate rights granted under state law and not a property right inherent in the land.
As to the character of the gain, which was essentially for the total amount realized, the Service argued that the gain was ordinary income since the credits were not capital assets. The Service cited the Gladden case as precedent, i.e., payments to relinquish water rights constituted ordinary income. See Gladden v. Comm’r, 112 T.C. 209 (1999), rev’d on a different issue, 262 F.3d 851 (9th Cir. 2011). The Court rejected this position finding that the credits themselves were not income based on the fact that the credits wre not contractual in nature and could not be used by the taxpayers. Judge Wherry, in his opinion, relied on the Supreme Court’s opinion in National Railroad Passenger Corp. v. Atchison, Topeka & Santa Fe Railroad Co., 470 U.S. 451, 465-466 (1985). Here, the Court found, there was no clear indication that the legislature of Colorado intended to bind itself contractually; ergo the state tax credit did not create any private contractual rights. Furthermore, the gains are not ordinary income based on the rationale that the proceeds received were a substitute for ordinary income. There was no finding that the credits when received were an accession to wealth to support an inclusion under section 61(a).
After finding that the state credits were no non-capital assets or a substitute for ordinary income, the Court further held that the gain was properly reported as short term capital gain as the requisite holding period was less than one year, i.e, the credits could not be "tacked onto" the holding period with respect to the land.