Tax issues

Condemnation Caveats

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.

IRC Section 1033

In 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.

Condemnation Rules

An 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.

Involuntary 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.

If 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.

Tax Consequences

If 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 gain.

Section 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.

Making the Replacement

To 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.

Eligibility Requirements

Condemned 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.

Replacement 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.

Replacement Period

A 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.

The 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.

Seymour Taub, CPA, JD

Seymour Taub, CPA, JD, is a partner at Eisner & Lubin LLP in New York who specializes in tax and accounting services. Contact him at (212) 829-3204 or staub@eisnerlubin.com.

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