Condemnations of Business and Income Producing Property

This article will explain the tax rules for determining a gain or loss from condemnations, how much of the loss is deductible or amount of gain taxable, and in what tax year, deferring gains from condemnations, and basis of replacement property when a gain is deferred. Also, an important aspect of replacement property is what qualifies as like-kind property to be able to defer the gain.

A condemnation is the threat or imminence of or the actual taking of property without the owner’s consent for public domain by a governmental agency through its power of eminent domain. Depending on the amount received and the adjusted basis of the property, a gain or loss may result. Part or all of a gain may be recognized and/or deferred.

Determining Amount of Gain or Loss

The realized gain or loss is the difference between the amount realized (generally, the amount received for the property less expenses incurred to obtain the amount awarded), less the adjusted basis. The recognized loss is generally the same as the realized loss. The amount of gain recognized depends if any or all of the gain is deferred by acquiring qualified like-kind replacement property within a required time period. Deferral of gain will be explained below. The recognized gain or loss will be treated as ordinary or Section 1231. If the asset was held for 12 months or less, it is ordinary; if held for more than 12 months it will be Section 1231 but if it is depreciable property, part of the gain will be treated as ordinary income under the depreciation recapture rules-Sections 1245, 1250, and 291. For a discussion of depreciation recapture rules, see my article “Sales of Business Property”]

Deferring Realized Gain

When business or income producing property is partially or wholly destroyed by a condemnation, and the taxpayer receives a monetary settlement and a gain results, an election can be made to defer the gain if the funds received are reinvested in qualified “like-kind” property within a prescribed time period. The gain to be recognized depends on the cost of the replacement property [Reg. 1.033(a)-2(c)(1)]. If the destroyed asset is replaced directly by like-kind property (no money is received) , the entire gain is deferred [Reg. 1.033(a)-2(b)].

A gain that results from a threat or imminence of condemnation, rather than actual condemnation, may be deferred if the taxpayer has reasonable cause to believe the property will be seized or condemned and this fact has been conveyed directly by the government agency [Rev. Rul. 63-221, 1963-2 CB 332; Balistrieri, TCM 1978-115]. The taxpayer may also sell the property to a third party rather than sell it to the governmental agency [Rev. Rul. 81-180, 1981-2 CB 161]. To defer a gain, the taxpayer must receive a notice directly from the governmental agency of its intention to proceed with a project and that the taxpayers property will be condemned if the project is finalized. The owner can not learn of the threat from news sources or other second-hand information [Rev. Rul. 58-557, 1958-25 CB 402]. If an individual purchases property that has been threatened with condemnation, the buyer may also defer any gain that results from a subsequent sale of the same property to the government when it is actually condemned [Rev. Rul. 81-181, 1981-2 CB 162].

Qualifying Replacement Property

The replacement property must be similar to or related in service or use to the property condemned [Sec. 1033(a); Reg. 1.1033(a)-1]. What is qualified property depends on the type of property condemned (personal or real) and its use (trade or business or as an investment as a lessor). The replacement test may also be satisfied by purchasing at least 80% of the voting stock of a corporation that owns the replacement property [Reg. 1.1033(a)-2(c)(1)]. But, the 80% stock purchase does not apply to condemnation of real property used in a trade or business or held for investment [Sec. 1033(g)(2)].

Functional use test.

Under this test, the replacement property must be used for the same purpose as the condemned property. This does not apply to real property used in a trade or business or any property held by an owner-investor (e.g., rental property).

Like-kind test.

This test applies to real property held for investment or used in a trade or business. Like-kind means the replacement property only has to be real property held by an owner-investor or owner-user [Regs. 1.1031(a)-1(a) and 1.1033(g)-1(a)]. Under the Sec. 1031 like-kind rules, improved real property can be replaced with unimproved real property or unimproved real property can be replaced with improved real property. Butt his code section has been overruled by Reg. 1.1033(a)-2(c)(9). This regulation states that there is no investment in similar property devoted to similar use if (1) the proceeds from condemnation of unimproved real property are invested in improved real property, or (2) proceeds are used to reduce debt previously incurred to purchase property.

Unproductive real property held for future use cannot be held as inventory [Sec. 1033(a)(2)(B); Reg.1.1033(a)-2(c)(3)].

Period for Acquisition of Replacement Property

If it is real property held by an owner-user or investor, replacement property must be acquired no later than three years after the end of the tax year in which the gain was realized (the year the proceeds for the condemnation are receive) [Sec. 1033(g)(4]. The replacement period begins at the end of the year, not the date the condemnation occurred.. It is not necessarily the same tax year the condemnation occurred because the condemnation or insurance proceeds may be received and the gain realized in the next tax year. If a taxpayer shows reasonable cause, an extension of the replacement period may be granted by the IRS but the request for an extension must be made before the replacement period expires [Reg.1.1033(a)-2(c)(3)].

Example 1:

John owns a building used as a photo studio and has a fiscal year ending June 30. On 5/1/2013, the building was condemned by the state for highway right-of-way. The monetary award was received on June 15, 2013 resulting in a realized gain. John has until 6/30/2016 to replace the destroyed building with another building to be used as a photo studio (like-kind property). This date is three years from 6/30/2013, the end of the fiscal year in which the building was condemned.

Example 2:

Robin has a fiscal year ending May 31. On 4/1/2013, her grocery store was condemned by the city to build an aquarium. She received the monetary award on June 15, 2013 resulting in a realized gain. Because the gain was realized in fiscal year 2014, to be able to defer the gain, she has until 5/31/2017 to replace the building and used as a grocery store.

Example 3:

Barb owns a condo held as rental property. Her tax year ends on December 31. On 2/1/13, the condo was condemned by the city to build a civic center. She received the monetary award on 6/1/2013 resulting in a realized gain. She has until 12/31/2016 to acquire new real estate to be used as a condo for rental.

Example 4.

Assume the same facts as example 3, except she only received a threat of condemnation. The new property must be acquired no later than 12/31/2016. The same replacement time period applies when a threat or imminence of condemnation occurs.

Basis of Replacement Property when Gain is Deferred

Two situations can occur when property is replaced: (1) no money is received and the condemned property is replaced directly with similar property, (2) money is received and the owner uses the money to purchase qualifying replacement property within the prescribed time period.

Direct conversion into similar property.

If similar property is received directly from the governmental agency, the realized gain is the excess of the fair market value (FMV) of the replacement property in excess of the adjusted basis of the condemned property. If there is a direct conversion into new property, the gain must be deferred [Sec. 1033(a)(1)]. The basis of the new property is the FMV of the replacement property less the realized (deferred) gain. The holding period of the old property tacks on to the new property [Sec. 1233(1)(A)].

Example:

On 7/1/2008, Bill purchased a building and used it for his CPA practice. On 11/1/2013 it was condemned by the state to be used for highway right-of-way. At that date the adjusted basis was $325,500. On 12/1/2013, the state replaced it directly with a similar building and Bill uses it for his CPA practice. The FMV of the new building is $375,800. He must defer the $50,300 realized gain ($375,800 – $325,500). The basis of the new building is $325,500 ($375,800 – $50,300). The holding period of the new building is the same as the old building (starting on 7/1/2008).

Receipt of money and purchase of qualified replacement property.

The realized gain is the condemnation proceeds, less any expenses of obtaining the award (e.g., attorney and appraisal fees) in excess of the adjusted basis of the condemned property. Interest received on delayed settlements is ordinary income and not part of the amount realized in determining the gain on the condemnation [Flushingside Realty & Construction Co., TCM, 6/10/43]. If the property was held for more than 12 months, any recognized gain is Section 1231. If held 12 months or less, the recognized gain is ordinary income. If a Section 1231 gain results, there may be depreciation recapture (ordinary income) if the condemned property is personal property depreciated using any method. If real property is depreciated using the straight-line method and the owner is a corporation, there is depreciation recapture under Sec. 291 ]See my article “Sales of Business Property” for examples).

Determining deferred and recognized gain.

The deferred gain is the excess of the realized gain over the recognized gain. The recognized gain is the lesser of (1) the realized gain or (2) the money received that exceeds the cost of the new property, assuming the property is replaced within the requisite time period. If it is not is replaced within the requisite time period or an extension is not obtained, the realized gain will be ordinary income in the year the replacement time period expires. To defer the entire realized gain, the replacement property must cost as much or more than the proceeds from the condemnation. The basis of the replacement property is its cost less the deferred gain. The holding period of the old property carries over to the new property [Sec. 1233(1)(A)]. If the property was held for more than 12 months any recognized gain is Section 1231. If held 12 months or less, the recognized gain is ordinary income. If a Section 1231 gain results, there may be depreciation recapture (ordinary income) if the condemned property is personal property depreciated using any method. If real property is depreciated using the straight-line method and the owner is a corporation, there is depreciation recapture under Sec. 291[see my article“Sales of Business Property” for examples].

Example 1. No cash received and direct replacement:

On 7/1/2008, John purchased a building for $255,000 and used for his CPA practice. On 11/1/2012, the building was condemned by the city to build a civic center. The adjusted basis was $222,000. On 12/1/2013, John received similar replacement property from the city with a value of $325,000 and will be used for his CPA practice. The realized gain is $70,000 ($325,000 fair value of replacement building less $255,000 adjusted basis of old building. No gain is recognized because when direct replacement occurs, deferral of any realized gain is mandatory. The basis of the new building will be $255,000 ($325,000 fair value of new building, less the $70,000 deferred gain). The holding period of the old building is tacked on to the new building.

Cash received and similar property purchased:

When cash is received and a gain is realized, a taxpayer may elect to defer it by purchasing qualified replacement property within the prescribed time period. Part or all of the realized gain may be recognized depending on the cost of the replacement property. If the property was depreciable real property, some of the recognized gain will be ordinary due to depreciation recapture. The holding period of the old building is tacked on to the new building.

Example 1. Cost of new building exceeds money received:

On 1/1/2008, Surf and Turf, Inc. purchased a building for $300,000 to used as a seafood restaurant in Albany, NY. They took straight-line depreciation over 30 years.. On 3/30/2013, the restaurant was condemned for highway right-of-way and the company received a cash settlement of $430,000. On 5/1/2013 a similar replacement building to be used as a sea food restaurant was purchased for $600,000. The adjusted basis of the old building was $257,500 with accumulated depreciation of $42,500. The realized, recognized gain, and basis of the new building is shown below:

Realized gain:

Money received                                       $430,000
Adjusted basis of old building              257,500
                                                                  $172,500

Recognized gain:

Money received                                      $430,000
Cost of new building                               600,000
Recognized gain                                          -0-

No gain is recognized because the new building cost more than the money received. The entire gain is deferred. Basis of new building:

Replacement cost                                   $600,000
Less deferred gain                                  (172,500)

                                                                     $427,500

Example 2. Cost of new building is less than money received:

Assume the same facts as Example 1, except the new building cost $400,000. Since the entire proceeds were not reinvested, part of the realized gain will be recognized. The amount and nature of the recognized gain and basis of the new building is shown below:

Recognized gain:

Money received                                        $430,000
Cost of new building                                 400,000

                                                                    $ 30,000

Nature of recognized gain:

Total gain                                                    $ 30,000
Depreciation recapture
under Sect. 291:
20% of the lesser of
$42,500 depreciation
allowed or $30,000)
recognized gain                                             6,000
Section 1231 gain                                     $24,000

Basis of new building:

Cost of new building                              $ 400,000
Less deferred gain:
Realized gain                        $172,500
Recognized gain                   ( 30,000)      142,500

                                                                       $257,500

Holding period of old building is tacked on to new building.

If the taxpayer fails to replace the condemned property within the allowed time period, any recognized gain must be reported on an amended return (form 1040X for proprietors and 1120X for corporations). for the year in which the realized gain occurred and must be filed within three years from the due date, including extensions, of the original return [Reg. 1-1033(a)-2(c)(2)].

Reinvestment of condemnation proceeds into a leasehold

In Ltr. Rul. 9543038, the IRS allowed a company to use the condemnation proceeds to purchase a leasehold to qualify as a like-kind exchange under Section 1033. The property was purchased by a holding company whose business was leasing land. The company owned and operated shopping centers and planned to acquire additional commercial properties. Two of the company’s properties were condemned by the state. The condemnation proceeds would be used to purchase leasehold interests in two properties, each of which is owned by one of the company’s wholly owned subsidiaries., which purchased the properties in an arms-length transaction. The IRS said the gain would be realized only to the extent of the amount realized that exceeded the cost of the leaseholds.[Note: It is important to keep in mind that a Letter Ruling is only applicable to the taxpayer that requested the ruling. But, other taxpayers and practitioner can use the ruling to get an idea of how the IRS will treat such transactions].

Tax return disclosure

When a taxpayer’s property has been condemned and a gain was realized and the taxpayer plans to purchase like-kind replacement property, this should be disclosed on the tax return by attaching a statement showing the details of the condemnation -type of property, condemnation proceeds, realized gain, and intention to purchase like-kind replacement property. In the year the property is replaced, the taxpayer must determine the recognized and deferred gain as well as the basis of the replacement property.

If the taxpayer does not replace the property within the prescribed time period and it is determined that a gain should have been recognized, an amended return must be filed within three years from the due date, including extensions, of the date the original return was due. Depending on whether part or all of the recognized gain, is ordinary, capital, or Section 1231 and its impact on other areas of the tax return, the amended return could result in additional taxes being owed. If this occurs, the IRS will charge interest on the additional tax due. If additional gains must be reported, this could affect the amount of Section 1231 losses allowed, and recaptured [see my article on “Sales of Business Property” for details of Section 1231 losses recapture], as well as other deductions limited by income (e.g., contributions and dividends- received deduction, NOL carry-backs and carry-forwards).

In accordance with Circular 230 Disclosure

Dr. Goedde is a former college professor who taught income tax, auditing, personal finance, and financial accounting and has 25 years of experience preparing income tax returns and consulting. He published many accounting and tax articles in professional journals. He is presently retired and does tax return preparation and consulting. He also writes articles on various aspects of taxation. During tax season he works as a volunteer income tax return preparer for seniors and low income persons in the IRS’s VITA program.

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