Understanding 1033 rules takes the confusion out of involuntary conversions.
The U.S. Supreme Court recently agreed to
decide the scope of a local government’s ability to use the power of eminent
domain to take private property. Several New London, Conn., residents contend
that the city’s condemnation of their homes is unjustified, while the city
wants to seize property for a mixed-use development. The residents argue that
the condemnation is not for public use, but the city believes the development
will provide jobs and increase the local tax base. While the Fifth Amendment
allows local governments this right provided just compensation is given for the
land, condemnation is becoming more controversial as land becomes scarcer
nationwide. Commercial real estate professionals can benefit greatly from
understanding condemnation’s tax implication for property owners.
general, gain or loss realized from the sale or other disposition of commercial
property must be recognized. Internal Revenue Code Section 1033 provides an
exception that allows a taxpayer to either recognize or defer gains resulting
from condemnations. The deferral provisions of Section 1033, which requires a forced
exchange of property, are more liberal than the rules in Section 1031, which
apply to voluntary like-kind property dispositions. Section 1033 provides for a
longer replacement period and eliminates the need for a qualified intermediary.
In addition, it also allows for the tax-free receipt of cash or other property
and does not require that the replacement property have the same mortgage
liability as the converted property.
involuntary conversion of property by condemnation or requisition occurs when a
governmental or quasi-governmental agency legally takes private property for
public use by exercising its power of eminent domain without the property
owner’s consent. This is contingent upon the payment of just compensation.
conversions also occur when property is sold or exchanged as the result of the
threat or imminence of requisition or condemnation. The threat or imminence of
condemnation exists before a sale or exchange when the property owner is
informed that the government intends to acquire the property and the
information conveyed to the owner gives him or her reasonable grounds to
believe that the property will be condemned if a voluntary sale to the
government is not arranged.
a taxpayer receives notice of intent to acquire the property before the
initiation of condemnation proceedings, a subsequent sale or exchange qualifies
as a disposition made under threat or imminence of condemnation. If a taxpayer
does not receive notice, he must demonstrate the reasonableness of his belief
that he was compelled to dispose of the property by the impending consequences.
the conversion is directly into “property similar or related in service or
use,” non-recognition of gain is mandatory as the replacement property has a
carry-over basis. If the proceeds of the conversion are cash or dissimilar
property, a valid Section 1033 election and qualified replacement results in
the recognition of gain only to the extent replacement property costs less than
the proceeds. The replacement property’s basis is reduced by the non-recognized
1033 regulations state that the 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. These details include
what replacement property was acquired, the date it was acquired, and its cost.
execute the 1033 exchange, the taxpayer must acquire the replacement property.
If the taxpayer (an individual or entity) that owns the condemned property
still is living or in existence, that taxpayer makes the replacement. Or, in
the case of a corporation, the corporation itself — not its shareholders — must
make the replacement, even if the corporation is liquidated. If a taxpayer who
receives the condemnation proceeds dies before he acquires replacement property
and the 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 Internal Revenue Service has ruled that
replacement and the election must be completed before a taxpayer’s death,
courts generally have allowed a decedent’s legal representative to acquire
replacement property and make the election under limited circumstances. If a
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 common will allow the individual
partners to make the election.
real property generally can be replaced by like-kind property, which is less
restrictive than the similar-use requirement for other involuntary conversions.
Not all condemned real property qualifies as like-kind: Only property that is
held for productive use in a trade or business or for investment is eligible.
property must be acquired by the purchase and the basis must be equal to the
cost. Thus, property acquired as a gift or exchange does not qualify. The
taxpayer must intend that the acquired property serve as the replacement for
the condemned property and should document that an acquisition was for a
replacement. The purchase requirement also could be satisfied through
construction of the replacement property. A taxpayer may use funds from any
source to purchase the replacement property and does not have to use actual
condemnation proceeds. Accordingly, the purchase price of replacement property
could include mortgages, whether or not they are assumed by the taxpayer, with
the resulting creation of cash flow.
taxpayer must replace condemned real property within the period beginning with
the condemnation and ending three years (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
the basis are received.
regulations require that notification of replacement be attached to the return
for the taxable year or years in which replacement occurs in order to avoid
keeping the period for assessment open. The notification must set forth all the
details in connection with the investment.