Burnley Empire Theatre defaulted to the care of the Duchy of Lancaster as an "owner of last resort" after the ownership could not be established.
Last used as a bingo hall in 1995, the Cow Lane venue was recently named the fifth most at risk theatre in the UK.
Campaigners who want to restore the building to its former glory said the decision was a blow to their plans.
Sophie Gibson from the Burnley Empire Theatre Trust (BETT), said: "This news came as something of a surprise and a disappointment.
"The viability study, which the council contributed to as well, is currently taking place and the results are due very shortly.
"If, as we hope, the verdict is a positive one we can then move on to stage two, the architectural planning phase for the project, when we also begin applying for funding.
"All of this could have been for nothing if it is auctioned off before we are able to get that far."
The Duchy of Lancaster, said it had been left with "no alternative" but to put it to bidders after offering it free of charge to both Burnley Council and the Theatre Trust - an offer that "remains open".
A spokesman added: "The Duchy remains hopeful that the building will remain in local ownership."
BETT said it could not yet afford the legal costs that would be incurred to take on the building.
The four-storey building, designed by  G. B. Rawcliffe, opened in 1894 as a music hall, before being converted to a cinema in 1938.
It is to be auctioned in Manchester on 16 October.

Fans got the happy ending they had been waiting for as the title character, created by Miranda Hart, got married.
The New Year's Day episode had 7.3m viewers, according to overnight figures.
The first part of the finale, shown on Christmas Day, had 6.7m viewers overnight.
Writing in The Independent, Neela Debnath said Miranda had drawn to a close "with a sweet and heart-warming ending".
"It's surprisingly touching and quite tender - that's not to say there aren't any pratfalls - but the finale is about Miranda standing up to her mother and accepting herself as she is."
Gerard O'Donovan, writing for The Telegraph, said: "New Year's Day brought all the humour and joy we could have wanted in a masterclass of romantic comedy writing and performance that teased and toyed, then delivered big on the happy ending, with a wedding."
Mark Lawson, writing in The Guardian, said: "As admirers had hoped, Miranda ended up on the floor twice in her comedy send-offs.
"But her expanding career, of which her inventive and well-acted sitcom is only a small part, suggests that her detractors are unlikely to get their wish of her falling metaphorically flat on her face."
Before the final show aired, Hart tweeted: "Happy New Year Day and goodbye to my creative baby day. 8pm BBC One. Can't promise but you MIGHT get a glimpse of that @GaryBarlow."
The show, which was first shown on BBC Two in 2009 before moving to BBC One, follows the trials and tribulations of Hart's character, a shop owner prone to committing social faux pas.
The programme also sees Patricia Hodge as her TV alter-ego's mother and Sarah Hadland as her shop's assistant manager.
The show, and its star, has won accolades from the Royal Television Society and the British Comedy Awards, among others.
The first episode of the third series was the most-watched television programme at Christmas in 2012.
The 41-year-old actress and comedienne is to star alongside Jude Law and Melissa McCarthy in American comedy Spy.
The film, directed by Bridesmaids' Paul Feig, is due to be released in UK cinemas in May.
An autobiographical book about Hart's life with her dog Peggy, Peggy And Me, will be also released this year.
A dilapidated Grade-II listed theatre, which has stood empty for over 20 years, is to be sold at auction.
[NEXT_CONCEPT]
TV critics are full of praise for the finale of sitcom Miranda, which has bowed out after five years.