Hotchpot

In property law, hotchpot (sometimes referred to as hotchpotch or the hotchpotch rule) refers to the blending of property in order to secure equality of division. It usually arises in cases of divorce or in connection with advances made from the estate of an intestate deceased.

Hotchpot has a similar meaning in the realm of tax law. "Hotchpot" refers to the blended group of Sec. 1231 gains and losses of the U.S. Tax Code. According to the Code, a section 1231 gain is comprised of:

1. Any recognized gain on the sale or exchange of property used in the trade or business, and

2. Any recognized gain from compulsory/involuntary conversion of

a. Property used in the trade or business, or

b. Any capital asset which is held for more than one year and is held in connection with a trade or business or a transaction entered into for profit

3. Into other property or money

4. Because of

a. Total or partial destruction

b. Theft or seizure

c. An exercise of the power of requisition or condemnation

d. Threat or imminence of such exercise

A section 1231 loss is any loss that occurs under the same circumstances required for a section 1231 gain. Under this definition, the term “property used in the trade or business” is subject to the limitations of Section 1231(b) of the Internal Revenue Code. Additionally, A capital asset is property held by the taxpayer, whether or not that property is connected with his trade or business, but not that which falls into the eight categories set forth in Section 1221(a). Those eight sections are:

1. Property held by the taxpayer primarily for sale to customers, or stock or inventory

2. Property used in a trade or business which is subject to depreciation in section 167, or real property used in trade or business

3. A copyright, composition, letter/memo, or something similar, held by the person who made the property, or, in the case of letter/memo, for whom the property was prepared/produced, or the person who determines the basis of such property

4. Accounts or notes receivable acquired in the normal course of trade or business for services rendered or sale of property to customers from stock/inventory

5. A publication of the U.S. Government which is received by the Government or one of its agencies, unless it is purchased at a public sale price and is held by the taxpayer who received it or the taxpayer who determines its basis

6. Any commodities derivative financial instrument held by such a dealer, unless the Secretary of the Treasury is satisfied that the instrument has no connection to the holder’s activities as a dealer and the instrument is clearly identified in the dealer’s records as such before the close of the day on which it was acquired, originated, or entered into

7. Any hedging transaction clearly identified as such before the close of the day on which it was acquired, originated, or entered into

8. Supplies of the type regularly used/consumed by the taxpayer in the ordinary course of trade/business

("See" http://en.wikipedia.org/wiki/Internal_Revenue_Code)

Hotchpot gains and losses are given preferential status by Section 1231 of the Code, a taxpayer-friendly policy that dates back to the World War II era. (Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials 519 (2nd ed. 2007). This preferential status allows hotchpot gains and losses to be treated as long-term capital gains and losses when the gains "are greater than" the losses (thereby treating the net gain at a more favorable tax rate), and allows them to be treated as ordinary income and ordinary losses when the gains are "less than or equal to" the losses (thereby allowing the losses to cancel out the income) (Id. at 522.) Under the Code, long-term capital gains are gains from the sale or exchange of a capital asset held for more than one year, if and to the extent that such gain is considered when computing gross income. Long-term capital losses are those from the sale or exchange of a capital asset held for more than one year, if and to the extent that such losses are considered in computing taxable income.

While the average taxpayer may have no need to identify "1231 gains and losses" as "Hotchpot gains and losses," that taxpayer likely benefits from the preferential tax treatment.

In addition, section 1231(a)(4)(C) contains a special rule for the purposes of determining whether a § 1231 gain or § 1231 loss enters the hotchpot. (Samual A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials. 521 (2nd ed. 2007)). This subsection states that if recognized losses from an involuntary conversion as a result of casualty or from theft, of any property used in the trade or business or of any capital asset held for more than one year, exceed the recognized gains from an involuntary conversion of any such property as a result of casualty or from theft, such losses and gains do not enter the hotchpot. 26 U.S.C. § 1231(a)(4)(C). Thus, section 1231 does not apply to gains and losses resulting from casualties and thefts if the losses exceed the gains. The practical effect of this subsection is that net losses from such involuntary conversions will be treated as ordinary income. Reg. § 1.1231-1(e)(3).Abolished by s1(2) Law Reform (Succession) Act 1995 in intestacy cases from 1st January 1996.