OWNER’S GUIDE TO AVOIDING TAX ON CONDEMNATION PROCEEDS THROUGH INTERNAL REVENUE CODE §1033 RELATING TO INVOLUNTARY CONVERSIONS
The Internal Revenue Code allows taxpayers to defer gain arising from condemnation award.
Ordinarily, when a taxpayer sells or exchanges property, he recognizes gain equal to the difference between his basis in the property sold or exchanged and the amount of money or fair market value of property received. However, section 1033 of the Internal Revenue Code (“IRC §1033”) permits a taxpayer to defer gain if the condemnation award (or proceeds from a sale made under threat or imminence of condemnation) are timely reinvested in similar property.
You might be familiar with the practice of deferring gain through like-kind exchanges under IRC §1031. The rules governing like-kind exchanges are strict, and the deadlines are short. Section 1033 provides a more relaxed procedure, with more generous deadlines, for avoiding gain arising from “involuntary conversions.”
Receipt of Funds is Not a Problem. When you reinvest under IRC §1033, you are allowed to have actual or constructive receipt of your condemnation or sale proceeds. Unlike under IRC §1031, you do not need to use a qualified intermediary or otherwise avoid constructive receipt.
Longer Replacement Periods. The normal deadline for reinvesting proceeds is two years after the close of the first taxable year in which any part of the gain is realized. If the property that was condemned or sold was real property held for productive use in trade or business or for investment, the reinvestment period is three years. Either deadline can be extended with IRS permission.
Relaxed Replacement Property Rules. You can use your proceeds to acquire property that is similar or related in service or use to the property that was condemned or sold. Under this rule, you can construct improvements on land you already own. You also can acquire a controlling interest in a corporation that owns qualified property. If the property that was condemned or sold was real property held for productive use in trade or business or for investment, you also are allowed to purchase property that is “like-kind.”
You Can Defer All or a Portion of Your Gain. The gain resulting from your condemnation or sale is taxable to the extent you have un-reinvested funds remaining at the end of your replacement period. However, you can make a strategic decision to recognize some gain so that you can use your proceeds for other purposes. You cannot offset un-reinvested proceeds with debt used to acquire replacement property, but, after you have reinvested, you can borrow against your replacement property.
Severance Damages Can Come Out Tax-Free. If any portion of your award or sale proceeds represents severance damages, rather than reinvesting those funds, you can simply reduce your basis in the retained property. If your severance damages exceed your basis, you can avoid gain by reinvesting the excess in qualified property.
Whether you expect to receive or already have received a condemnation award (or sold property under threat of condemnation), you may be able to defer your taxable gain. Clark Hill has extensive experience helping clients benefit from IRC §1033 and would be pleased to assist you.