Accountant details condemnation rules. (Insiders Outlook).

General Rule

In general, gain or loss realized from the sale or other disposition of property must be recognized. Section 1033 provides an exception that allows a taxpayer to either recognize or defer gains resulting from involuntary conversions (losses subject to other code provisions are recognized). An involuntary conversion is the forced exchange of property into cash or other property by reason of destruction, theft, seizure, or requisition or condemnation or threat thereof. While the deferral of gain is desirable there is a cost in the requirement to reduce basis in the replacement property with the resulting reduction in depreciation deductions.

Definition

An involuntary conversion of property by condemnation or requisition occurs when a governmental or quasi-governmental agency legally takes private property for public use, without the property owner's consent, but upon the award and payment of just compensation. That is, a Section 1033 requisition or condemnation is a taking that requires compensation under the Fifth Amendment. Condemnations include the granting of an easement and right of way to an electric utility for transmission lines, the granting of scenic easements and the withholding and sale by the Environment Protection Agency of air pollution allowances.

Condemnation does not include every governmental action that diminishes a taxpayer's property rights. For example, no compensation is required under the Fifth or Fourteenth Amendments to the U.S. Constitution when the government prohibits particular contemplated uses of property after reasonably concluding that doing so promotes the health, safety, morals or general welfare of its citizens.

If only a portion of property is condemned or requisitioned, or if property is partially destroyed, the proceeds from the voluntary sale of the remainder of the property become proceeds from an involuntary conversion if the involuntarily converted property cannot be adequately replaced, and there is a substantial economic relationship between the converted property and the property sold so that together they constitute one economic unit. If the portion of the property remaining after a partial destruction, condemnation, or requisition can function independently of the portion converted, or if the property could have been replaced, the sales proceeds are not considered proceeds from an involuntary conversion.

Tax Consequences

If the conversion is directly into "property similar or related in service or use" non-recognition of gain is mandatory. The replacement property has a carryover basis. If the proceeds of the conversion is cash or dissimilar property a valid Section 1033 election and qualified replacement results in the recognition of gain only to the extent the cost of replacement property is less than the proceeds. The basis of the replacement property is reduced by the non-recognized again.

The regulations provide that the Section 1033 deferral is deemed elected by omitting the gain from the condemnation on the tax return. However, all the details in connection with the condemnation of property at a gain must be provided on the return for the years in which any portion of the gain is realized in order to close the tax year from audit. These details include, what replacement property was acquired, the date acquired, and the cost to the taxpayer.

Making the Replacement

The taxpayer must acquire the replacement property. If the taxpayer who owns the condemned property is still alive or in existence that taxpayer makes the replacement. A corporation itself and not its shareholders must make the replacement. This is so even if the corporation is liquidated. If a taxpayer who receives the proceeds of a condemnation dies before he acquires replacement property and replacement property is acquired by the decedent taxpayer's executor or testamentary trustee, there is a conflict of authority as to whether the election can be made. Although the IRS has ruled that replacement and the election must be completed before the taxpayer's death, courts generally have allowed the legal representative of a decedent to acquire replacement property and make the election in limited circumstances. If partnership property is converted, the election and replacement must be made by the partnership. However, a timely distribution of the property before condemnation to its partners as tenants-in-comm on will allow the individual partners to make the election.

Replacement Property

Condemned real property generally can be replaced by like-kind property, which is less restrictive than the similar use property requirement for other involuntary conversions. Not all condemned real property qualifies for like kind: only that which is held for productive use in a trade or business or for investment is eligible. Thus, real property which is inventory or used as a residence is not eligible.

Replacement Period

A taxpayer must replace condemned realty property within the period beginning on the earlier of the condemnation or treat or imminence thereof and ending three year (two years if not condemnation of real property) after the close of the first taxable year in which any part of the gain is realized. In general, gain is realized as soon as proceeds in excess of basis are received. This period can be extended upon application to the Internal Revenue Service.