An involuntary conversion is the taking or destruction of property without the consent of the property owner, such as partial or complete destruction, theft, condemnation, or a sale or exchange of the property that was done in anticipation of the condemnation by a government.
Under IRC §1033, Involuntary Conversions, a taxpayer can postpone any realized gain to the extent that the taxpayer reinvests the compensation for conversion into replacement property. Realized gain is not recognized if the total amount reinvested exceeds the amount realized. If the reinvestment amount is less, then the difference is recognized as gain. If the taxpayer suffers a loss on the involuntary conversion, then §1033 does not modify any rules for loss recognition.
Condemnation, as used in §1033, is the taking of private property for public use. A condemnation does not qualify under §1033 if the property was condemned because it was unfit for habitation or if the property owner was forced to sell to pay for delinquent taxes. An involuntary conversion does not include any voluntary acts, such as when the taxpayer destroys his own property. In all of these cases, the owner of the property was the cause of the conversion, either through neglect or through willful acts, so the conversion was not involuntary.
If the taxpayer disposes of the property because of an imminent condemnation of the property, then the taxpayer must provide evidence that the condemnation was decided by the authorities, and that the taxpayer reasonably believed that the property would be taken. If the condemnation was learned from the news media, then the IRS requires the taxpayer to verify that with a public official from the condemning authority. To qualify under §1033, the taxpayer does not have to sell to the condemning authority, but can sell to a third-party, who may be more capable of obtaining a better price.
If the involuntary conversion involves a principal residence, then the gain may be excluded under the principal residence exclusion rules. Any gain realized on a principal residence that exceeds the exclusion amount can be postponed by reinvesting that amount for replacement property.
Replacement property can be bought from a related party and qualify for tax-free treatment if the gains from the involuntary conversions are $100,000 or less.
The replacement property must be purchased within the replacement period to qualify for the tax deferral, which ends after the following number of years after the tax year of the conversion:
- personal-use property, 2 years;
- business investment property:
- 2 years for the destruction or theft of the property;
- 3 years for condemnation of the property;
- a residence destroyed by a disaster in a federally declared disaster area, 4 years.
The 2-year replacement period applies to business, investment, or personal property that was destroyed, damaged, or stolen. The period starts when the property was converted, and ends 2 years after the tax year of the conversion. The 3-year replacement period applies to business or investment real estate property that has been condemned and begins on the earlier of the notification of the condemnation or the disposition of the condemned property, and ends 3 years after the 1st tax year in which gain is realized on the condemnation. Any property bought before the condemnation or its threat will not qualify as replacement property.
Example: On January 1, 2015, your undeveloped real estate is condemned for which you are paid $30,000. Your basis is $20,000. Therefore you can defer tax on the gain of $10,000 if at least $30,000 is invested in other real estate no later than December 31, 2018, which is 2 years after the tax year of the condemnation.
The replacement requirements are more restrictive than for like-kind property under §1031, and depend on whether the taxpayer is an investor or a business owner. If the taxpayer is an investor, then the taxpayer use test applies, where the investor can replace the converted property with another similar investment property, even if they are not the same type. For instance, a residential rental property can be replaced by a commercial rental property, or a manufacturing plant can be replaced with a warehouse, since both spaces can be rented. However, if the taxpayer is the owner of the business, then the functional use test applies, so the taxpayer must replace the property with property that is functionally similar and serves the same use in the business. However, this test may be satisfied for a business by purchasing a controlling interest of 80% or more of a corporation owning similar property to the converted property. Business or investment property that was damaged or destroyed in a federally declared disaster area can be replaced with any tangible property acquired for business use.
Special rules apply for real property used in a business or investment that is condemned. The replacement rules allow a greater flexibility in choosing replacement property, such as replacing raw land with developed land. In a direct conversion, the taxpayer receives the replacement property instead of money, in which case, the nonrecognition of realized gain is mandatory, and the replacement property acquires the carryover basis of the converted property; gain is recognized upon the disposition of the replacement property. However, if the taxpayer is compensated for the conversion by payment, then the taxpayer must elect to postpone the recognition of the gain; otherwise the realized gain is recognized in the year that it occurred.
If the replacement property cannot be bought within the required time period, then the taxpayer should seek an extension of time from the IRS during the replacement period. If the request is made afterwards, then the taxpayer must give a reasonable reason for delaying the extension request.
Deferring Recognized Gain
A taxpayer may elect to recognize losses rather than deferring them if it is more advantageous, such as being able to claim higher depreciation expenses for the new property. Otherwise, to defer the tax, the taxpayer must notify the IRS of that intention, giving transaction details, including when the replacement property is expected to be purchased. If a partnership suffered the conversion, then the partnership must elect to defer the gain. Individual partners cannot make their own elections, unless the partnership is terminated under IRS rules.
If the taxpayer elects to pay the tax rather than defer the gain, but buys similar property later, then the taxpayer can elect to defer tax on the gain by filing an amended return.
Tax Basis and Recognized Gain
The tax basis in the replacement property = its cost – any postponed gain. The entire gain is reported if the replacement cost = the adjusted basis of the converted property.
If fire insurance covers a loss of several or many items of property, then the IRS requires that the gain or loss must be assessed on each item rather than as a whole.
Recognized Gain = Conversion Proceeds – the Greater of Replacement Property Cost or the Adjusted Basis of the Converted Property
Example: You have a house used as rental property with a tax basis of $200,000 that is condemned by the state for which it pays $230,000. You use the proceeds to buy another house rental for $220,000.
- Total Gain = $230,000 – $200,000 = $30,000
- Recognized Gain = $230,000 – $220,000 = $10,000
- Deferred Gain = $220,000 – $200,000 = $20,000
- Adjusted Basis of New Property = $220,000 – $20,000 = $200,000
Condemnation awards may be reduced by condemnation expenses, such as legal, engineering, or appraisal fees. Payments made directly to the mortgagee (lender) of the property are not deductible, since they are not included in the income of the taxpayer. If the authority pays interest because of late payments, then that income must be reported as interest. Even if the authority does not designate any income as interest, the IRS may treat some of the payment as interest if the payments were late.
Any gain from severance awards may also be postponed. Severance awards are usually awarded when only part of the property is condemned, causing the remaining property to lose value. Severance awards are usually equal to the total received by the property owner minus the compensation given for the property itself:
Severance Award = Total Compensation – Compensation for Property
Severance awards will not be recognized as taxable income if either of the following is true:
- the severance damages are used to increase the value of the remaining property, or
- the property is sold and replaced at a cost equal to or exceeding the total of the condemnation award, sales proceeds, and the severance damages:
- Replacement Property Cost ≥ Condemnation Award + Sales Proceeds + Severance Award
Relocation payments are not considered part of the award and are not taxable if spent for relocation; instead, the basis of the newly acquired property is increased by the amount of the relocation expense payment. Insurance proceeds may cover the cost of business interruption and for the loss of property; however, the part of the proceeds that is attributable to the business interruption insurance is fully taxable as ordinary income.
Form 4684, Casualties and Thefts is used to report involuntary conversions due to theft or casualty. Condemnation conversions are reported on Form 4797, Sales of Business Property for business or investment property and Schedule D, Capital Gains and Losses for personal-use property.