Tax Court expands Sec. 1033's scope.

• Author: Barton, Peter
• Position: Property conversion

The Tax Court ruled in Willamette Industries, 118 TC No. 7 (2002), that Willamette could use Sec. 1033's involuntary-conversion provisions to defer gain on damaged property, even though Willamette processed and sold the property in the same manner as undamaged property. The court also allowed the taxpayer to defer the gain, even though it was almost as large as it would have been if the property had not been damaged. This ruling provides more options for taxpayers with partially damaged involuntarily converted property.

Sec. 1033(a) provides that "if property (as a result of its destruction in whole or in part) is compulsorily or involuntarily converted" any gain would not be recognized if the property were converted into money used to purchase replacement similar property. Thus, Sec. 1033 allows a taxpayer to postpone gain recognition until it sells the replacement property. In Rev. Rul. 72-372, the Service denied involuntary-conversion treatment when an uninsured taxpayer sold trees damaged in a hurricane, even though the trees would have decayed or been destroyed by insects if not sold. The IRS pointed out that there was no direct conversion into money (as typically occurs when damages or insurance proceeds are paid).

However, in Rev. Rul. 80-175, which also involved the sale of trees damaged in a hurricane, the Service revoked Rev. Rul. 72-372. It concluded that the taxpayers satisfied Sec. 1033's requirements, which was to allow them to postpone recognizing gain when compelled to dispose of involuntarily converted property. Therefore, Rev. Rul. 80-175 eliminated the requirement that the taxpayer convert the damaged property directly into cash. Citing Masser, 30 TC 741 (1958), Rev. Rul. 80-175 held that the conversion event must render the property "unfit or impractical for its intended use." The IRS distinguished Willis, 41 TC 468 (1964), in which the Tax Court denied involuntary-conversion treatment, because the damaged property (a ship) was repairable, which made its sale voluntary.

In Willamette Industries, an Oregon corporation grew and processed trees into lumber, plywood and paper products. In 1992-1995, wind, ice storms, wildfires and insect infestations damaged some of Willamette's crop. To avoid further loss from insects and decay, Willamette salvaged the damaged trees and cut them into logs. It processed the logs into wood and paper products, instead of selling the damaged trees or the logs to third parties. Therefore, except...