State Tax Credits as Capital Assets

George H. Tempel, et ux. v. Commissioner, 136 T.C. No. 15

How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?

I have been sitting on this case for a while now.  It's part of the pile of late tax season developments that  I have been slogging through.  As I study it more I am surprised that it does not seem to have generated a lot of interest.  Many states hand out tax credits to encourage all sorts of different activities.  Cleaning up brownfields, rehabilitiating historic structures, making movies.  Sometimes the credits are transferable.  The transfer of those credits will have federal income tax consequences.  A recent case about Virginia credits concerned whether payments were for the credits or capital contributions to a parntership. What is the nature of the income from the sale of the credit ?  Frankly, I thought it was pretty obvious that somebody who does something like making a film that generates a credit, which is sold, should offset the expenses by the proceeds of the credit.  So there would either be an expense reduction or the reduction in the basis of a capital asset.  Well, silly me.  The holding in this case is that the transfer of the state credit creates capital gain.

In 2004 Ps donated a qualified conservation easement to a qualified charitable organization. As a result, Ps received conservation easement income tax credits from the State of Colorado. These credits were transferable to other taxpayers. That same year Ps sold a portion of those credits.



Ps reported short-term capital gains from the sales of the State credits. Ps claimed an allocated portion of the professional fees they incurred to complete the conservation easement donation, as adjusted basis in the State tax credits they sold.

R determined the State income tax credits that Ps sold were not capital assets and that Ps had no adjusted basis in the credits. R filed a motion for partial summary judgment and Ps filed a cross-motion. In their cross-motion, Ps also claim that proceeds from their sales of State tax credits should have been reported as long-term capital gains.

On December 17, 2004, petitioners, George and Georgetta Tempel, husband and wife, donated a qualified conservation easement to the Greenlands Reserve, a qualified organization, on approximately 54 acres of petitioners' land in Colorado. Petitioners claimed the fair market value of their donation was $836,500. They incurred $11,574.74 of expenses in connection with the donation that primarily consisted of various professional fees. As a result of the donation petitioners received $260,000 of conservation easement income tax credits from the State of Colorado.
 Petitioners sold $110,000 and gave away $10,000 of their $260,000 of State tax credits, leaving them with $140,000 of State tax credits to use. There is no evidence and respondent does not assert that petitioners sold credits they could have otherwise used to receive a refund. Therefore, petitioners' proceeds from the sale of their credits are not a substitute for a tax refund.


It is also apparent that the transferred State tax credits never represented a right to receive income from the state. Instead, they merely represented the right to reduce a taxpayer's State tax liability. It is without question that a government's decision to tax one taxpayer at a lower rate than another taxpayer is not income to the taxpayer who pays lower taxes. A lesser tax detriment to a taxpayer is not an accession to wealth and therefore does not give rise to income.

The defiinition of a capital asset is "property held by the taxpayer".  Essentially everthing is a capital asset except for the specific things that are not such as stock in trade or a copyright in the hands of the person who produced the work.  We don't need to get into the whole list.  It suffices that state tax credits are not included. There is a doctrine that something that is a substitute for ordinary income is not a capital asset even if it is not specifically excluded.  As outlined above, that is not the case with state credits.

Conclusion The State tax credits petitioners sold do not represent a right to income; therefore, the substitute for ordinary income doctrine is inapplicable. None of the categories of property in section 1221 that Congress specifically excepted from the term capital asset is applicable to the State tax credits. Accordingly, we hold the State tax credits petitioners sold are capital assets.

The taxpayers had argued that they had basis in the credits. On the intial return it was the fees that they had incurred in structuring the easement.  In the case they argued that a portion of the basis in the land should be allocated to the credits.  The Court rejected both those arguments.

The taxpayers also tried to argue that their holding period for the credit should be a tacked holding period from the land.  The Court also rejected that argument indicating that the holding period for the credit begins when it is issued. 

This decision might be very significant for some taxpayers.  If they can hold state credits for a year after they are issued they will be able to get long term capital gain treatment.