Discussion:*Cringe* Another Earnest Money Question

In spite of the fact that i might be completely flamed on this thread, i have a couple of questions i'm looking for answers to that I Have not found by searching the boards.

Here Goes: This is primarily an income question. Situations have arisen that have had clients retaining earnest money/deposits/option payments put down for purchase/eventual purchase of 1250 property (raw land in most cases). Everything that I've found has indicated that in all scenarios, this money is ordinary. Is there any authority that you're aware of to the contrary, and if so, please let me know.

Research that i've found related to retained earnest money under a sale scenario point to retained earnest money as liquidated damages, and as such, the ordinary income argument relies upon the Harold S. Smith v. Commissioner 50 TC 276. Court said the following “The payments they (the taxpayers) received were not gains from the sale of capital assets, for there was no completed sale.” “The payments arose out of the contract and were the price the buyer paid and they, the sellers, agreed to accept upon default as payment for the restrictions they agreed to place upon their business operations during the sale period. They received what they bargained for. We hold… that the amounts so received are taxable as ordinary income. ”

From the option scenario's standpoint, retained 'option payments': Reg. Sec. 1.1234-1(b) states that “In general, any gain to the grantor of an option arising from the failure of the holder to exercise it… is considered ordinary income or loss”. Per the regulations under Sec. 1234, the exceptions to this general rule relate to grantors of options on stock, securities, commodities, or commodity futures. It is therefore (in my findings) , through a lack of exclusion under the general rule of Reg. Sec. 1.1234-1(b), that gain to the grantor of a lapsed/expired real estate option must recognize such gain as ordinary.

questions/comments/points to the contrary? I'm looking for 1231 treatment on these retained monies.

come on guys, in the words of Hillary (Nurse Ratchet) Clinton "let's talk, let's chat, lets start a dialogue"

Thanks.

this month.

Yes, the question is whether or not the character of these items is ordinary or capital. or, furthermore, wheter or not 1231 status has any effect on the aforementioned question.

Thanks

Well, at least you're on board Donnie... good stuff :P

Dugan,

Regarding your comments on your client from '04, that seems to be in line with what i'm finding. the gain or loss from the 'sale or exchange' of, or loss attributable to the expiration of an option is treated according to the underylying property as it would be in the hands of the optionee, however the gain attributable to expiration of an option in the hands of the optionor, is ordinary income.

Treatment in the case of retained earnest money/depost by the seller in a failed sale also treated as ordinary in my research.

Anyone have anything to the contrary?

I have a difficult time deciphering the context of Sec. 1234A and there seems to be painfully little secondary sources/discussion on it in RIA. so if you could elucidate a bit, it would be greatly appreciated, as the only thing i've found on point (the smith case mentioned above) indicates treatment to the contrary.

dont get me wrong, i want you to be right, i just want to know why in clearer context.

Thanks for the reply

In another thread: [[1]] Riley2 made a comment on Sec. 1234A and the fact that it was modified by the 1997 taxpayer relief act to cover real property. anyone know of a plain english explanation of the modifications mad under the act?

and what falls under the umbrella a 'right or obligation' (*cough!* academia academia)

b) Failure to exercise option. If the holder of an option to buy or sell property incurs a loss on failure to exercise the option, the option is deemed to have been sold or exchanged on the date that it expired. Any such loss to the holder of an option is treated under the general rule provided in paragraph (a) of this section. In general, any gain to the grantor of an option arising from the failure of the holder to exercise it, and any gain or loss realized by the grantor of an option as a result of a closing transaction, such as repurchasing the option from the holder, is considered ordinary income or loss.

Agreed. Your thoughts on retained earnest money in a failed sale?

I'm not sure i understand your post. could you please explain your comments?

No offense intended, but i cannot make sense of what you're trying to say or comparisons/contrasts that you're trying to draw. You seem like you're confident in what you're saying, but for the sake of the less experienced/informed (me), would you please lay out more fully what you're saying?

Many thanks

Is anyone aware of authority to the contrary of the initial post? I'm trying to find out if there is anything out there to hang my hat on (wow, what an outdated phrase), to allow retention of earnest money (as liquidated damages) by the seller in a failed sale on real estate to be treated as anything other than ordinary?

Dennis addressed income on an expired option to a grantor, which is in line with my research, and unfortunately, sounds like ordinary income to the grantor.

Also, Can real estate sale or option contracts be considered as under the umbrella of Sec. 1234A since the 1997 tax relief act passed? if that is the case, is there any authority to support?

Well if anyone posts anything after this, much appreciated. i'll be checking back often.

You might want to take a look at Daugherty v. Commissioner. Also, here's a link to an interesting article: http://www.woodporter.com/ma/120302.htm. It mostly deals with breach of contract proceeds though, which I am not sure is on point. Best of luck!

http://taxalmanac.com/index.php/Internal_Revenue_Code:Sec._1234A._Gains_or_losses_from_certain_terminations

what circumstances need to arise to trigger 1234A treatment and not Reg. Sec. 1234-1(b)/harold smith treatment?

That's where i'm getting caught up. any thoughts?

"Prior to September 4, 1997, such amounts were treated as ordinary income. Reg. §1.1234-1(b); Rev. Rul. 57-40, 1957-1 C.B. 266. However, §1234A, which was added to the Code by the Taxpayer Relief Act of 1997 (“TRA ‘97”), now provides that any gain arising from a lapse or other termination of a “right” with respect to property which is a capital asset in the hands of the taxpayer will be treated as gain from the sale of a capital asset. An option may be treated as a “right” with respect to property. However, the Conference Committee Report under TRA ’97 indicates that gains from the lapse of an option will be treated as arising from the sale or exchange of the property subject to the option “to the extent provided in Treasury regulations” issued under §1234A. Conf Com Rpt 521. Thus, sale or exchange treatment will be accorded to gains derived from the lapse of an option only if and to the extent provided in regulations to be promulgated by the Secretary, which to date have not been issued. Therefore, the treatment of gains from the lapse of an option with respect to real property will presumably continue to result in ordinary income unless and until regulations providing to the contrary are issued." 2005 source