IRC 1234A: Gains or Losses from Certain Terminations

IRC Section 1234A treats a gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation as a capital gain or loss, so long as the underlying property is (or would be) a capital asset in the taxpayer’s hands.¹ No actual sale is required. The termination itself is treated as if the taxpayer had sold a capital asset.

What the Rule Does and Why It Exists

Under the general rule in Section 1222, a gain or loss qualifies as capital only when it arises from a “sale or exchange” of a capital asset. Before 1981, canceling a contract or letting it lapse was not technically a sale or exchange, so courts often treated the resulting loss as ordinary. That mattered enormously, because ordinary losses offset all types of income dollar-for-dollar, while capital losses can only offset capital gains plus $3,000 of ordinary income a year.

Taxpayers exploited the gap with offsetting forward contracts. They would hold both legs until the long-term holding period passed, sell the winning leg for long-term capital gain at preferential rates, and cancel the losing leg for a fully deductible ordinary loss. Congress shut this down with Section 1234A as part of the Economic Recovery Tax Act of 1981, originally targeting forward contracts for foreign currency and securities. In 1997, Congress extended the provision to rights and obligations tied to all types of capital-asset property, including interests in real and personal property that are not actively traded.

The Four Terminating Events

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 flowing from one side to the other.
Lapse, where the contract dies on its own terms because a condition was never met or a deadline passed without action.
Expiration, where the contract reaches its stated end date and the rights and obligations simply cease.
Other termination, a catch-all that captures anything else that extinguishes the economic position. Offsetting a futures contract by taking the opposite position is the most common example. Forfeiting a deposit under a purchase contract also fits here.

The common thread is that the taxpayer’s economic interest ends without a transfer of the underlying property. When one of these events occurs and the capital-asset test is met, the result is capital gain or capital loss.

When the Underlying Property Must Be a Capital Asset

Section 1234A only applies when the underlying property is, or would be if acquired, a capital asset in the taxpayer’s hands.¹ The “would be” language matters because many contracts grant a right to acquire property the taxpayer does not yet own. You test the character of the property as if the taxpayer had actually acquired it.

Section 1221 defines capital assets by exclusion: everything a taxpayer holds qualifies unless it falls into one of several listed categories.² The main exclusions:

Inventory and stock in trade held for sale to customers in the ordinary course of business.
Depreciable business property and business real estate used in a trade or business.
Self-created copyrights, literary works, and similar intellectual property in the hands of the creator.
Hedging transactions entered in the normal course of business, if properly identified.

If a manufacturer terminates a forward contract to buy raw materials that would be inventory, the resulting gain or loss is ordinary. Section 1234A simply does not apply. The analysis runs independently for each party, so property might be a capital asset on one side and inventory on the other.

The Section 1231 Trap

This catches many taxpayers off guard. Depreciable business property and real estate used in a trade or business receive favorable capital gain treatment when sold at a profit under Section 1231, but they are specifically excluded from the Section 1221 capital asset definition.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.

The practical consequence: terminating a contract to acquire a commercial building or piece of business equipment likely produces ordinary gain or loss. The Section 1231 preference only kicks in on an actual sale or exchange of the property itself.

Hedging Transactions

Section 1221(a)(7) excludes hedging transactions from the capital asset definition when the taxpayer properly identifies the hedge before the close of the day it is entered into.² A hedging transaction is one entered in the normal course of business primarily to manage price changes or currency fluctuations tied to ordinary property or ordinary obligations.³

Because a qualifying hedge is not a capital asset, terminating one produces ordinary gain or loss regardless of Section 1234A. The identification requirement is strict; failing to identify a hedge on a timely basis can trigger severe consequences under the regulations.

How the Gain or Loss Is Taxed

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

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

On the loss side, the characterization bites hard. Capital losses can only offset capital gains, with any excess limited to $3,000 a year against ordinary income and the remainder carried forward indefinitely.⁴ Before Section 1234A existed, a taxpayer could terminate a losing contract and deduct the full ordinary loss against wages, business income, or any other source. That is precisely the advantage Congress eliminated.

Section 1256 Contracts

A separate paragraph of Section 1234A independently covers Section 1256 contracts (regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts) that are capital assets but are not already covered by paragraph (1).¹ Section 1256 then imposes its own regime: gains and losses are split 60% long-term and 40% short-term regardless of actual holding period.⁵ Section 1234A establishes that the result is capital; the 60/40 split governs how it is reported.

A Note on Scope

Section 1234A does not cover every derivative. Options have their own regime under Section 1234, and securities futures contracts (futures on individual securities or narrow-based security indexes) are explicitly carved out and handled under Section 1234B.⁶

Where Section 1234A Shows Up in Practice

Futures and Forward Contracts

The most common Section 1234A scenario involves offsetting a futures position. A speculator who buys a gold futures contract and later sells an identical contract to close the position has engaged in an “other termination” of the original obligation. If the contract was held as a speculative investment rather than as business inventory, the underlying property is a capital asset and capital treatment follows. Privately negotiated forward contracts work the same way. Canceling a forward for a cash settlement payment triggers Section 1234A when the capital-asset test is met.

Variable Prepaid Forward Contracts

Variable prepaid forward contracts (VPFCs) have generated significant litigation. In Estate of McKelvey, 161 T.C. 130 (2023), the Tax Court held that extending a VPFC and ultimately receiving stock constituted a termination of obligations under Section 1234A. Because the underlying stock would have been a capital asset, the termination produced capital gain or loss. VPFCs appear frequently in executive compensation and concentrated stock position planning, so the holding has broad reach.

Breakup and Termination Fees

When a merger or acquisition falls apart, the party that walks away often pays a breakup fee. Whether Section 1234A applies has been a moving target. The IRS initially treated breakup fees as ordinary income to the recipient without applying Section 1234A. More recently, in internal guidance, the IRS has taken the position that a breakup fee received by a would-be purchaser in a failed deal should be treated as capital gain under Section 1234A, since the right to acquire the target’s stock was a right with respect to property that would have been a capital asset. Taxpayers involved in deal terminations should treat this as an unsettled area where the IRS position may depend on specific facts.

Swaps and Non-Standard Derivatives

Lump-sum payments to terminate a swap or other non-standard derivative can also fall under Section 1234A. If a taxpayer receives a payment to unwind a long-term interest rate swap, the character of that payment depends on whether the underlying reference qualifies as property that is a capital asset. Notional principal contract regulations provide separate timing rules for periodic payments, but a termination payment that extinguishes the entire position is tested under Section 1234A’s framework.

How to Report a Section 1234A Termination

Gains and losses characterized as capital under Section 1234A are reported on Form 8949 and flow to Schedule D, like any other capital gain or loss. The termination date serves as the disposition date, and the holding period runs from the date the taxpayer acquired the right or obligation to the termination date. For Section 1256 contracts, the 60/40 split is reported on Form 6781 instead.⁷ Taxpayers holding offsetting positions that qualify as straddles under Section 1092 face additional loss deferral rules that can delay 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
Office of the Law Revision Counsel. 26 U.S. Code 1234B – Gains or Losses From Securities Futures Contracts
7
Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles