Archive for April 6th, 2011

The tax on long-term capital gains is currently 15%. The highest tax rate on ordinary income is currently 35%. For obvious reasons, taxpayers prefer long-term capital gains.

In order to enjoy the benefits of the lower capital gains rate, however, you must have sold or exchanged  a “capital asset.” While that sounds simple enough, what consitutes a capital asset is has been heavily litigated; the vague definition in Section 1221 serving as the culprit.

Section 1221, to its detriment, defines capital assets by exclusion: a capital asset is any asset other than inventory, depreciable property, a copyright or similar right, accounts receivables, and some lesser-seen asset types we won’t touch on here.

Due to this ambiguity, taxpayers have long tried to treat certain assets, such as stock exchange seats, lottery tickets, contract rights and solar credits, as capital assets. 

Today, in Tempel v. Commissioner, 136 T.C. 15 (2011), the Tax Court tackled this issue once more, and determined that the sale of Colorado state tax credits generated capital gain.  In Tempel, the taxpayer made a qualified conservation easement donation and received credits to offset Colorado state income tax. Colorado allows you to sell your tax credits, and the taxpayer did, reporting the gain as capital gain.

The Tax Court agreed, basing their decision on the fact that 1) the state credits were not one of the stautorily-excluded classes of assets considered not to be capital assets under Section 1221, and 2) the “replacement of ordinary income” doctrine did not apply.

The replacement of ordinary income doctrine dictates that you can’t sell an asset that would have otherwise generated ordinary income and treat the sale as capital gain. For example, if Joe wins the lottery and is entitled to $100,000 a year for 10 years, he has a choice. He can sit back and collect his winnings, and each payment will generate ordinary income to him. Conversely, he could sell the right to the future payments for say, $800,000, and try to treat the sale of the lottery ticket as a capital asset, resulting in $800,000 of capital gain. This position will fail, however, because the “replacement of ordinary income” doctrine will remove the lottery ticket from the definition of capital assets, since if Joe simply collected his winnings, they would have been taxed as ordinary income.

The Tax Court did not agree with the IRS’s contention that the sale of state tax credits was merely a substitute for ordinary income. The credits merely represented the right to reduce a taxpayer’s state income tax liability; and a lesser tax bill is not the same as the taxpayer generating ordinary income. It’s important to note, while the court agreed that the credits were capital assets, they also concluded that the holding period of the credits started on the day they were granted; not on the day the underlying land was purchased. This meant the capital gain was short-term, rather than long-term.

While the taxation of the sale of lottery tickets is well established, it will be interesting to see if this case has implications for assets whose classification is still uncertain, such as SRECs (solar renewable energy certificates) and PSLs (personal seat licenses granting the taxpayer the right to purchase season tickets for professional sports teams).

Could the same methodolgy implemented in Tempel — simply running through the gamut of Section 1221 exclusions and the replacement of ordinary income doctrine — be utilized to conclude that SRECs or PSLs are capital assets?

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