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Section 1033 of the Internal Revenue Code is specifically designed to give relief to property owners who have lost land through an "involuntary conversion." A qualifying involuntary conversion occurs when a property or a portion of one is destroyed, stolen, condemned, or disposed of under the threat of condemnation, and other property or money is received in payment.
The majority of individuals and corporations we've worked with to complete their Section 1033 exchanges have involved proceeds received from the sale of a property sold under threat of condemnation in the process of being taken via eminent domain.
"Eminent domain incommon law legal systems is the inherent power of the state to seize a citizen's private property,expropriate property, or rights in property, without the owner's consent. The property is taken either for government use or by delegation to third parties who will devote it to "public use or civic" or in some cases, economic development. The most common uses of property taken by eminent domain are public utilities, highways, and railroads. Some states require that the government body offer to purchase the property before resorting to the use of eminent domain.
The term "condemnation" is used to describe the formal act of the exercise of the power of eminent domain to transfer title to private property from its rightful owner to itself. It is not to be confused with the same term that describes a declaration that real property, generally a building, has become so dilapidated as to be legally unfit for human habitation due to its physical defects. This type of condemnation of buildings (on grounds of health and safety hazards or gross zoning violation) usually does not deprive the owners of the title to the property condemned but requires them to rectify the offending situation or have the government do it for them and bill them for the cost.
Condemnation via eminent domain indicates the government is taking the property or an interest in it, such as an easement. In most cases the only thing that remains to be decided when a condemnation action is filed is the amount of just compensation, although in some cases the right to take may be challenged by the property owner on the grounds that the attempted taking is not for a public use, or has not been authorized by the legislature, or because the condemnor has not followed the proper procedure required by law." (http://en.wikipedia.org/wiki/Eminent_domain)
In particular, states, counties, cities, and other government entities often find it necessary to acquire realty, sometimes against the wishes of the property owner. If a taxpayer's property is involuntarily converted by a governmental or quasi-governmental agency through a condemnation or a negotiated sale under the threat of condemnation and the taxpayer has a gain resulting from the involuntary conversion, he or she may elect to postpone recognition of that gain by buying a qualified replacement property within a specified replacement period. The basis of the taxpayer's replacement property is reduced by the non-recognized gain.
The tax deferral provisions of §1033 are, in many ways, more generous to the taxpayer than the §1031 rules. For instance, the §1033 roll-over exchange does not require application of the technical rules of a §1031 exchange. As a result, there are no concerns about the taxpayer's constructive receipt of funds and no requirement that a qualified intermediary be involved in the transaction.
With respect to the condemnation of held either for "productive use in trade or business or for investment", §1033 provides that a taxpayer has a period of three years to roll over the proceeds into a new investment property that is "similar or related in service or use to the property so converted."
- Under this special rule, conversion of real property into "property of like-kind" to be held for either business use or investment is considered a conversion into property "similar or related in service or use" and qualifies for Section 1033 treatment. The term "real property" as used here means land, and generally anything erected on, growing on, or attached to the land. The nature and character of each property should be considered.
- Under the special real property rule, all qualified real estate is like-kind with all other qualified real estate. This like-kind test is the same as that found in Section 1031 exchanges and it does not matter if your condemned property or your replacement property is improved or unimproved. As a result, a Tenant-In-Common (TIC) Fractional Ownership Interest may qualify as a like-kind replacement property.
- Keep in mind that the IRS also treats the following, when condemned, as like-kind property if held for use in business or for the production of income:
- Easements.
- Rights-of-way.
- Leaseholds for a term of 30 years or more. The term includes the initial term of the lease and all optional renewal periods.
- Perpetual water rights, if they are considered real property rights under state law.
- Any similar continuing interests in real property.
The Replacement Time Period
Generally, the replacement period for a Section 1033 involuntary conversion begins upon the earlier of: i) the date of disposition of the condemned property; or ii) the date the property is first subject to threat of condemnation or seizure. Obtaining a threat letter from the condemning authority can assist the taxpayer in establishing the exact commencement date.
In Rev. Rul.63-221, the IRS ruled that a threat or imminence of condemnation is generally considered to exist if you obtain information through a news medium as to a decision to acquire your property for public use. The following two conditions must be met:
- You must obtain confirmation from a representative of the governmental body involved as to the correctness of the published report.
- You must have reasonable grounds to believe the property will be condemned if a voluntary sale is not arranged.
To qualify as a threat:
- The other party must have the legal power to condemn or requisition, and
- Must make a threat of condemnation, or there must be a known imminence of condemnation.
A threat of condemnation need not be a certainty. It exists if it might reasonably be believed from representations of government agents and surrounding circumstances that a condemnation is likely to take place.
Replacement of the condemned property must be completed by the end of the replacement period. Merely exerting best efforts, or having construction in progress will not satisfy the requirement. Making the Election
Unlike Section 1031, unless the relinquished property is directly converted into qualifying replacement property, the taxpayer must make a valid election to qualify for the Section 1033 roll-over. The election is made by the taxpayer purchasing the replacement property within the replacement period and filing a claim for a tax refund for each year in which gain from the conversion of the condemned property was reported.
The Replacement Amount Requirement - Calculating Gain
To avoid recognition of all the gain, the cost of the replacement property must equal or be more than the net proceeds received for the condemned property. The net proceeds are the total proceeds reduced by the expenses incurred in securing the award and any special assessments levied against remaining property resulting from the installation of an improvement. If the cost is less, the difference is recognized as gain and the excess is treated just like boot received in a Section 1031 like-kind exchange. It's taxable.
Other considerations include:
- If only part of your property is condemned, you must allocate the basis between the condemned part and the remaining part. If the property is unimproved land, you allocate based on original cost. If the condemned part is improved real estate, you may use a relative value allocation based on market or assessed values.
- If you used part of your condemned property as your home and part as a business or rental property, you must treat each part as a separate property and figure your gain or loss separately for each part.
- If interest is paid on your award to compensate you for delay in payment, it is taxed as ordinary interest income. It is not treated as part of the award.
- Sometimes the governmental authority condemning your property will levy an assessment against the remaining property. This assessment is usually withheld and reduces the award you get. The assessment is made under the theory that the portion of property you retain is benefited by the improvement for which the condemnation was made. A withheld assessment reduces the gross award for purposes of figuring gain or loss on the condemnation.
Severance Damages
Severance damages are distinct from the condemnation award, They are paid for injury to the property whereas award payments are for the property taken from you. If you receive severance damages, figuring the gain on conversion gets very complicated. Severance damages are compensation paid to you in addition to the condemnation award. They are paid because part of your property is condemned and the value of the part retained by you is decreased because of the condemnation. Examples are impairment of access, flooding or erosion of the property retained, replacement of fences, trees, etc., to restore the retained property to its former use.
If severance damages are included in the award, the amount of the special assessment withheld must first reduce these severance damages. The balance is used to reduce the amount of the award for the condemned property.
Condemnation expenses must be allocated between the severance damage payments and the condemnation proceeds. Net severance damage payments are applied to reduce the basis of the retained property. If the payment is more than the basis, the difference is realized gain. This gain qualifies for non-recognition under 1033.
No Tax or Legal Advice
It should now be clear that the rules of Section 1033 are a legal matter and quite complex. Therefore, it is very important that you not rely on the information presented on this Web site but rather discuss tax and legal matters with your accountant, attorney, or other qualified person. Due to the complexity of the rules regarding the replacement period, taxpayers should consult their attorneys or tax advisors in order to avoid pitfalls regarding the replacement period.
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