Tax Tips
| Publication year | 1978 |
| Pages | 198 |
| Citation | Vol. 7 No. 2 Pg. 198 |
1978, February, Pg. 198. Tax Tips
Absent § 1033 of the Internal Revenue Code,(fn1) the receipt of a condemnation award or insurance proceeds as a result of the condemnation or destruction of property would be a taxable transaction in which the taxpayer would recognize as gain (or loss) the difference between the proceeds received and his tax basis in the property condemned or destroyed.(fn2) However, if the taxpayer reinvests the proceeds in similar property, it would appear to be an inappropriate time to tax any gain, particularly considering the involuntary nature of the transaction. Accordingly, Congress enacted § 1033 to permit the taxpayer to elect to defer recognition of his gain.
In general, § 1033 provides that if property is involuntarily converted and if the proceeds of the conversion are timely reinvested in qualifying property, then the taxpayer's gain on the conversion is not recognized, if the taxpayer so elects.(fn3) However, the taxpayer's basis in the property purchased with the condemnation or insurance proceeds is reduced by the amount of gain not recognized,(fn4) with the result that the gain will be recognized on a deferred basis, either as the result of reduced depreciation deductions or as increased gain (or decreased loss) on the resale of the property acquired with the proceeds.
An "involuntary conversion" within the meaning of § 1033 consists of the "destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof," of property. There are no limitations as to the type of property subject to the involuntary conversion rules: § 1033 is applicable to personal and real property, tangible and intangible property, and property used in the trade or business, property held for investment, inventory, and property used for personal purposes. However, § 1033 applies only to conversions of property; therefore, business interruption insurance payments for lost profits are recognized as ordinary income.(fn5)
In general, there is no problem in determining whether property has been destroyed or stolen. The IRS eliminated one potential problem by ruling that, unlike the casualty loss provisions of § 165, the destruction of property need not be sudden in order to qualify for § 1033.(fn6) The occurrence of a seizure, requisition or condemnation is normally also readily determinable, except for generally unsuccessful taxpayer attempts to expand the coverage of the statute to include transactions such as a foreclosure to satisfy an assessment or tax lien,(fn7) a condemnation of property for violation of health or safety standards,(fn8) or a voluntary sale to achieve some business advantage.(fn9) With respect to condemnations, it should be noted that the condemning body need not be a government or a governmental authority; a condemnation of property by a public utility would also qualify for § 1033 treatment.(fn10)
Most of the litigation that has occurred with respect to whether an involuntary conversion has occurred relates to whether a sale was made as a result of the threat or imminence of condemnation or was made voluntarily. In the latter event, § 1033 would not apply. As long as the taxpayer has reasonable grounds to believe and does believe that his property will be condemned if not voluntarily sold, then the sale amounts to an involuntary conversion even if the threatening body has not officially authorized condemnation,(fn11) or has not appropriated any funds for condemnation,(fn12) or does not even have the power to condemn, as long as it could obtain such power if desired.(fn13)
By special statutory provisions, the sale of property pursuant to the acreage limitation provisions of federal reclamation laws, the sale or destruction of diseased livestock, and the sale of draft, breeding or dairy livestock on account of drought are all treated as involuntary conversions.(fn14)
By statute, the reinvestment period commences with the earliest of the threat or imminence of condemnation or the destruction, threat, seizure, requisition or condemnation itself and ends two years after the close of the first taxable year in which any part of the gain upon the conversion is realized.(fn15) This means that the taxpayer can purchase replacement property prior to the receipt of insurance proceeds (as long as the purchase occurs after the destruction or theft) or prior to the receipt of the condemnation award and even before the actual condemnation itself (as long as the purchase occurs after the threat or imminence of condemnation arises).(fn16)
Several observations are in order with respect to the termination of the replacement period. First, the taxpayer has the...
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