Condemnation and Involuntary Conversions
Originally placed in the Tax Code in 1921, Internal Revenue Code Section 1033 governs the tax consequences when a property is compulsorily or involuntarily converted in whole or in part into cash or other property.1 This
is commonly referred to as an involuntary conversion since the loss of property is beyond the control of the taxpayer. There is no requirement under Section 1033 that a third party accommodator—as a qualified intermediary in an IRC §1031 tax-deferred exchange—be employed to hold the conversion proceeds.
A conversion may be either direct, where a property is converted directly into similar property, or, more commonly, indirect, where property is converted into cash or dissimilar property.2 The deferral of gain from a direct conversion is mandatory. The deferral of gain realized in an indirect conversion is elective and certain steps need to be taken in order to receive non-recognition treatment.
A property is involuntarily converted when one of four events occurs:
- a. The property is destroyed by fire, earthquake, hurricane, or some other destructive event.
- b. The property is taken by theft (usually personal property).
- c. The property is seized (generally without compensation, making this conversion somewhat irrelevant).
- d. The requisition or condemnation of the property…
(i) ..occurs through governmental exercise of its power of eminent domain. Must be compensable and involuntary.
(ii) ..occurs through a sale due to an imminent threat of a requisition or condemnation. The property owner must be aware of the threat and must reasonably believe that a condemnation is likely to occur.
The two most common indirect conversions are those by destruction, which is usually compensable through insurance payouts, and condemnations through eminent domain proceedings. The condemning governmental agency is required under the U.S. Constitution to “[j]ustly compensate” its citizens for any loss they suffer due to a governmental taking of property.3
In some instances, only a portion of a property could be involuntarily converted. For example, under the power of eminent domain, a city might take a building owner’s parking lot, but not the building. If the taking of the parking lot renders the operation of the building economically impractical, then the property owner could sell the building as part of the original conversion and defer capital gain from the building sale as well.4 Known as the Masser Doctrine, this tax court decision allowed for the involuntary conversion of all property within the same economic unit.5
In an IRS ruling, the Service stated “[W]here all the facts and circumstances show a substantial economic relationship between the condemned property and the other property sold by the taxpayer, so that together they constituted one economic property unit, such as existed in the Masser case, involuntary conversion treatment for the proceeds of the voluntary sale will be permitted.”6
Replacement Property and Timelines
Whenever a property is involuntarily converted, it must be replaced within a specific timeline with a property of equal value in order to receive complete tax-deferral. The type of property, and its use at the time of conversion, are important factors in determining how long a taxpayer has to acquire a replacement property, as well as the specific kind of property to be acquired. Additionally, the manner in which it was involuntarily converted (e.g., destruction or condemnation) can narrow the replacement property choices for a taxpayer.
The replacement period starts from the earliest of: a) the date the converted property is disposed of; or b) the date of a threat or imminence of requisition or condemnation. The replacement period ends anywhere from two to four years (see below) from the end of the tax-year during which any part of the gain is realized.7Personal Use Property
Real estate used for personal enjoyment, such as a principal residence or vacation/second home, can only be converted into property similar or related in service or us. This effectively means only property used in a similar manner and for a similar purpose to the converted property can be acquired.9 For example, if a principal residence is destroyed in a hurricane, then only other property used by the taxpayer for personal enjoyment (such as another residence or, alternatively, a second home. 10) can be acquired. There is no requirement, however, that obligates someone to acquire exactly the same type of property (e.g., a condominium for another condominium). A taxpayer could replace a single-family house used as a vacation home for a condominium used as a primary residence. The courts have been rather generous over the years in determining whether a replacement property is similar or related in service or use to a converted property, so it is best to check with a tax advisor prior to proceeding with a replacement property acquisition.
Whenever property subject to the provisions of §1033(a) is involuntarily converted, a taxpayer has two years from the end of the tax-year in which any part of the conversion gain is realized (i.e., those amounts received above basis) to replace the converted property with one of equal value.11
There is a special exception to the two-year rule where there is a destruction of a residence or its contents located in a presidentially declared disaster area. In those instances, the replacement period is extended to four years from the end of the tax year where there is receipt of condemnation proceeds.12Property Held for Productive Use in a Business or Trade or for Investment
If a rental or other property used in a business or trade is involuntarily destroyed, the same replacement rules apply (see Personal Use Property, above). There is, however, a major distinction when this type of real estate is condemned or sold under threat of condemnation. The replacement period is extended to three years and the definition of what type of property can be acquired is made more lax.13
Condemned realty or that sold pursuant to a threat of eminent domain which is used in a business or trade or held for investment14 can be replaced with like-kind replacement property applying the same liberal standards afforded IRC §1031 exchanges. Like-kind describes any type of real estate provided it is held for productive use in a trade or business or for investment. Examples would be raw land, any income producing realty such as commercial or residential rental, and even oil and gas property. Unlike the more stringent “similar or related in service or use” standard, the replacement property does not have to be used be in the same manner and for the same purpose.
For conversions due to condemnation or a sale due to the threat or imminence thereof, there is a three-year replacement period beginning at the end of the tax year the condemnation proceeds are received.15
Special Rules Under §1031
There are a few unique aspects of IRC §1033 that make an involuntary conversion easier to complete than other tax-deferral provisions in the Tax Code. One of the most obvious is that the timelines can be extended. This is accomplished by filing an application for extension with the appropriate district director. The taxpayer’s excuse for needing an extension must be reasonable.16
There does not appear to be any requirement under IRC §1033 that the proceeds from the conversion be reinvested into the replacement property. Unlike the stricter rules of tax- deferred exchanges,17 it appears an involuntary conversion requires the acquisition of replacement property be only of equal or greater value.18 This would allow equity received from the original conversion to be offset with new debt on the replacement property.
A replacement property can be acquired prior to an actual conversion when a reasonable threat or imminence of condemnation has been communicated to the property owner.19 This, of course, would only apply to those conversions where a property owner sells pursuant to the threat of an eminent domain action.
A taxpayer can acquire a replacement property outside the United States for a converted property located inside the United States.22
Finally, the replacement property standards of IRC §1033 are met by acquiring at least eighty percent (80%) of all outstanding voting stock of a corporation that owns similar, qualifying real estate.23
Having been installed in the Tax Code decades ago, Section 1033 involuntary conversions are of great benefit to those unfortunate taxpayers, who unexpectedly lose their property. While the loss of one’s real estate will usually prove to be a stressful time, at least the use of an involuntary conversion will allow ample opportunity to avoid payment of taxes due to profit realized from the conversion. It is always advisable to speak with tax counsel whenever something of the magnitude of an involuntary conversion transpires.