IRC 1234A: Gains or Losses from Certain Terminations

IRC Section 1234A treats the gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation as if it came from the sale of a capital asset, provided the underlying property is (or would be) a capital asset in the taxpayer’s hands. No actual sale has to happen. The rule converts what might otherwise be an ordinary gain or loss into a capital one, which usually helps on the gain side and hurts on the loss side.¹

The Four Terminations That Trigger the Rule

Section 1234A reaches four ways a contract can end without a traditional buyer-seller transaction:¹

Cancellation, where the parties mutually agree to end the contract, often with a termination payment.
Lapse, where the contract expires on its own terms because a condition was never met or a deadline passed.
Expiration, where the contract reaches its stated end date and the rights and obligations cease.
Other termination, a catch-all covering anything else that extinguishes the position. Offsetting a futures contract by taking the opposite position is the most common example; forfeiting a deposit under a purchase contract fits here too.

The common thread is that the taxpayer’s economic interest in the contract ends. When that happens and the underlying property test is met, capital treatment follows.

The Capital Asset Test

Section 1234A only applies if the underlying property is, or would be if acquired, a capital asset in the taxpayer’s hands.¹ That “would be” language is important. Many contracts grant a right to acquire property the taxpayer doesn’t yet own, so you test the character of the property as if the taxpayer had actually acquired it.

Section 1221 defines a capital asset by exclusion: everything a taxpayer holds is a capital asset unless it falls into a listed exception.² The major exclusions are:

Inventory and stock in trade held for sale to customers in the ordinary course of business.
Depreciable business property and business real estate.
Self-created intellectual property in the hands of the creator.
Properly identified hedging transactions entered in the normal course of business.

A manufacturer that cancels a forward contract to buy raw materials gets ordinary treatment, because the raw materials would have been inventory rather than a capital asset. Section 1234A never comes into play. The analysis runs independently for each party, so the same contract can be inside 1234A for one side and outside it for the other.

Section 1231 Property Is Not a Capital Asset

This catches taxpayers off guard. Depreciable trade or business property and business real estate get favorable capital-gain-like treatment on sale under Section 1231, but they are specifically excluded from the capital asset definition in Section 1221.² The Tax Court confirmed the point in CRI-Leslie v. Commissioner, 147 T.C. No. 8 (2016), holding that Section 1231 property does not qualify as a capital asset for purposes of Section 1234A.

Practically, if you terminate a contract to acquire a commercial building or a piece of business equipment, the resulting gain or loss is likely ordinary. The Section 1231 preference only kicks in when you actually sell or exchange the property, not when a contract related to it terminates.

Hedging Transactions Sit Outside the Rule

A hedging transaction, entered in the normal course of business primarily to manage price or currency risk tied to ordinary property or ordinary obligations, is not a capital asset if properly identified before the close of the day it’s entered.²³ Terminating a valid hedge produces ordinary gain or loss regardless of Section 1234A. The identification requirement is strict, and missing it can produce harsh results under the regulations.

How the Gain or Loss Gets Taxed

When Section 1234A applies, the gain or loss is treated as arising from the sale of a capital asset.¹ Whether it’s short-term or long-term turns on how long the taxpayer held the contract itself. More than a year is long-term; a year or less is short-term.⁴

Long-term capital gains are taxed at 0%, 15%, or 20% depending on taxable income, while short-term gains are taxed at ordinary rates. High-income taxpayers may also owe the 3.8% Net Investment Income Tax on capital gains under Section 1411.

On the loss side, capital treatment is often the worse outcome. Capital losses only offset capital gains, plus up to $3,000 of ordinary income per year, with any excess carried forward indefinitely.⁴ That is exactly the outcome Congress wanted after taxpayers spent years using contract terminations to manufacture ordinary losses on the losing leg of a straddle while taking long-term capital gain on the profitable leg. Section 1234A closed that door in 1981 and was expanded in 1997 to reach rights and obligations tied to all types of capital-asset property, including interests in real and personal property that isn’t actively traded.

Section 1256 Contracts

Section 1234A contains a second paragraph that independently covers Section 1256 contracts (regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts) held as capital assets, in case they aren’t already captured by the first paragraph.¹

In practice, Section 1256’s own regime usually drives the reporting. Gains and losses on Section 1256 contracts are split 60% long-term and 40% short-term regardless of actual holding period.⁵ Section 1234A gets you to capital; the 60/40 split then governs how the numbers land on Form 6781.⁶

Section 1234 and 1234B: Where the Lines Are

Three adjacent code sections split derivative instruments among themselves, and they are easy to confuse.

Section 1234 covers options. For the option purchaser, gain or loss from selling the option or from failing to exercise takes the character of the underlying property; a loss from letting an option expire worthless is deemed to occur on the expiration date. For the grantor of an option on stocks, securities, or commodities, gain or loss from a closing transaction or lapse is short-term capital.⁷

Section 1234A covers bilateral contracts where both sides have binding rights and obligations, such as forwards and futures, along with any other right or obligation tied to capital-asset property that doesn’t fit Section 1234’s option framework.¹

Section 1234B covers securities futures contracts (futures on individual securities or narrow-based security indexes). Section 1234A expressly excludes those from its scope.⁸

Where Section 1234A Actually Shows Up

Futures and Forward Contracts

The most common scenario is closing a futures position by taking an offsetting one. A speculator who bought a gold futures contract and later sells an identical contract to close has engaged in an “other termination” of the original obligation. If the gold contract was held for speculation rather than as business inventory, the resulting gain or loss is capital. Privately negotiated forward contracts work the same way; canceling one for a cash settlement triggers Section 1234A when the underlying property passes the capital asset test.

Variable Prepaid Forward Contracts

Variable prepaid forward contracts have produced significant litigation. In Estate of McKelvey, 161 T.C. 130 (2023), the Tax Court held that extending a VPFC and ultimately delivering stock was a termination of obligations under Section 1234A, and because the underlying stock would have been a capital asset, the termination produced capital gain or loss. VPFCs turn up frequently in executive compensation and concentrated stock planning, so this holding matters.

Merger Breakup Fees

When a deal falls apart and the walking party pays a breakup fee, the tax character has moved over time. The IRS initially treated breakup fees as ordinary income to the recipient without applying Section 1234A. More recently, the IRS has taken the position in internal guidance that a breakup fee received by a would-be purchaser should be capital under Section 1234A, on the theory that the right to acquire the target’s stock was a right with respect to property that would have been a capital asset. Taxpayers should treat this as an unsettled area where the answer may depend on the facts.

Swaps and Non-Standard Derivatives

Lump-sum payments to terminate a swap or other non-standard derivative can fall under Section 1234A. A payment received to unwind a long-term interest rate swap gets its character based on whether the underlying reference is property that is a capital asset. Notional principal contract regulations supply their own timing rules for periodic payments, but a termination payment that extinguishes the entire position is tested under Section 1234A.

How to Report It

Gains and losses characterized as capital under Section 1234A go on Form 8949 and flow to Schedule D. The termination date is the disposition date, and the holding period runs from acquisition of the right or obligation to that termination date. Section 1256 contracts are reported on Form 6781 with the 60/40 split.⁶ If the terminated position was part of a straddle under Section 1092, additional loss deferral rules can push recognition of a loss on the terminated leg until the offsetting position is also closed.

1
Office of the Law Revision Counsel. 26 U.S. Code 1234A – Gains or Losses From Certain Terminations
2
Office of the Law Revision Counsel. 26 U.S. Code 1221 – Capital Asset Defined
3
eCFR. 26 CFR 1.1221-2 – Hedging Transactions
4
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
5
Office of the Law Revision Counsel. 26 U.S. Code 1256 – Section 1256 Contracts Marked to Market
6
Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles
7
Office of the Law Revision Counsel. 26 USC 1234 – Options to Buy or Sell
8
Office of the Law Revision Counsel. 26 U.S. Code 1234B – Gains or Losses From Securities Futures Contracts