Involuntary Conversions

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Involuntary Conversions

• Patrick Hennessee
• CPA, PhD

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1033 -Involuntary Conversions

• May postpone gain realized from the conversion
• Objective
• Provide relief for taxpayers who
• Suffered a hardship
• No wherewithal to pay tax on gain
• Postponement to extent amount realized reinvested
  in replacement property

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Rules for Nonrecognition of Gain

• Amount reinvested in replacement property
• equals or exceeds amount realized, realized gain
  is not recognized
• less than amount realized, realized gain
  recognized to extent of deficiency
• Elective or Mandatory
• depending on the facts

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Non recognition
Amount Realized 45,000 Adjusted Basis
30,000 Gain Realized 15,000
Amount Reinvested ---- 40,0000
Gain Recognized --- 5,000
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Involuntary Conversion
Indirect Conversion
Direct Conversion
Elective
Mandatory
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Involuntary Conversion

• Destruction
• Theft
• Seizure, requisition or condemnation
• Sale or exchange under threat of above
• Must obtain confirmation of decision to acquire
  property for public use
• Reasonable grounds to believe property will be
  taken
• Not voluntary acts

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Amount Realized

• Include only amount received as compensation for
  the property
• Normally, dont include severance damages
• Usually awarded because value of other property
  has declined because of the condemnation
• Reduce basis of remaining property
• Nonrecognition provision applies to severance
  damages if
• Severance damages used to restore remaining
  property or
• Usefulness of remaining property is destroyed
• Property is sold replaced at a cost equal to or
  exceeding the award (damages sales proceeds)

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Marco S Marinello Assn. Inc., 1975 PH T.C. Memo
392

• Seven of the 18 holes of a golf course were
  condemned. Although 11 holes remained, it was
  anticipated that the course would have to be
  reduced to 9 holes. Therefore, 21,000 of the
  condemnation award was allocated to severance
  damages to reflect the decline in value. It was
  not included in the amount realized and reduced
  the basis of the remaining property.

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Test Your Understanding
State of Oklahoma condemns a portion of Rs land
to build a highway. Because the highway denies
Rs cattle access to a pond, R receives severance
damages of 50,000 in addition to the
condemnation proceeds for the land. The
remaining land has a basis to R of 40,000. What
results?

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Test Your Understanding
Same facts as before, except that R used the
proceeds from the condemnation and the severance
award to build another pond. What results?
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Amount Realized-Condemnations

• Government makes award to mortgagee to satisfy a
  mortgage on the condemned property, this amount
  is considered as part of the amount realized.

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Test Your Understanding

• Johnson has acquired some land worth 100,000
  subject to a 50,000 mortgage and in a
  condemnation proceeding the government awards her
  60,000 and awards the martgagee 50,000 in
  satisfaction of the mortgage. What is the amount
  realized to Johnson?

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Replacement Property

• Generally more restrictive than like kind
• Must be similar or related in service or use
• Different interpretations apply to
• Owner-users and
• Owner-investors (lessors)
• Owner-user ltgt functional use test
• Owner-investor ltgt taxpayer use test

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Owner-Investor vs Owner-User

• Taxpayer Use Test (owner-investor)
• Broader in scope
• Must be used by the taxpayer in similar endeavors
• Rental property replaces other rental property
  regardless of type of rental
• Functional Use Test (owner-user)
• Use of property must be same
• More restrictive

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Functional Use Test

• Example Rev. Rul. 76-319
• Replacement of a bowling alley destroyed by fire
  with a recreational billiards center did not pass
  the functional use test

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Taxpayer-Use Test

• Applies to rental property owned by an investor
• Principal requirement
• Owner-investor must lease out the replacement
  property that was acquired
• Note - lessee is not requried to use the leased
  property for the same functional use

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Rev. Rul. 71-41

• Taxpayer owned land and a warehouse held for
  rental purposes
• Upon the involuntary conversion of the property,
  taxpayer invested the proceeds in a gas station
  on land he already owned.
• The IRS used the taxpayer-use test and taxpayer
  was able to defer the gain

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Test Your Understanding

• Jane owns a movie theater that was destroyed by a
  tornado. She uses the insurance proceeds to
  purchase a skating rink. Will this be considered
  property that is similar or related in service or
  use under the functional use test?

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Special Rules

• Business or investment real property is condemned
• More flexibility in replacement property
• Improved real property can be replaced with
  unimproved real property

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Obtaining Replacement Property

• General rule
• Must purchase replacement property
• Adjusted basis must be cost
• So, property acquired by inheritance or gift does
  not qualify
• May purchase a controlling interest in a
  corporation that owns replacement property (80
  control)
• Does not apply to condemnations of real estate--
  using like-kind property

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Test Your Understanding

• Halls airplane, used in business was hijacked
  and taken to a foreign country. He used his
  insurance proceeds to to purchase 80 of Fast
  Corporation stock. Fast owns an airplane which
  qualifies as replacement property. Does this
  satisfy the involuntary conversion requirement?

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Test Your Understanding

• Lous farm is condemned by the state for public
  use. He used the proceeds to purchase 80 of
  Verd Corporation stock. Verd owns eight parking
  lots.
• Has a qualified replacement property been
  obtained?

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Time Limit on Replacement

• General rules
• 2 years after close of tax year which gain
  realized to replace
• gives you up to 3 years to replace
• Condemned real property
• 3 years after close of tax year which gain
  realized to replace
• gives you up to 4 years to replace

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Time Limit on Replacement
1/12/16
12/31/96
12/31/97
12/31/99
12/31/98
Gain Realized
Last day to replace
Condemned Real Estate
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Test Your Understanding
Ms warehouse is destroyed by fire on 12/16/96.
The adjusted basis is 325,000. M receives
400,000 from the insurance company on 1/10/97.
M is a calendar year taxpayer. When is the
latest replace- ment date?

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Test Your Understanding
Assume same facts, except Ms warehouse is
condemned. When is the latest date for
replacement?
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Test Your Understanding
Taxpayer purchased agricultural land and
buildings to be held for investment purposes for
220. Taxpayer then leased the property to a
farmer. Then, a portion of the property was
condemned by the state of Oklahoma to make way
for a highway. The remaining property was not
adequate to sustain a profitable farming
operation. Taxpayer received 175 from Oklahoma
for the property actually taken and 135 for
"severance damages." A proper allocation of
Taxpayer's basis was 140 to the portion actually
taken and 80 to the remaining portion.
Therefore, a gain of 35 (175 - 140) was
realized on the property actually taken, and a
gain of 55 (135 - 80) was realized on the
remaining portion. Without making an effort
either to restore the utility of the retained
property or to locate property in the same area
as the condemned property, Taxpayer, within the
period of time set forth in 1033 Code,
purchased for 350 a large motel complex.
Taxpayer actively managed and directly operated
the motel for its own account.
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1) Can Taxpayer defer the recognition of gain
realized from "severance damages" received as
part of a condemnation award by reinvesting in
like-kind property under 1033(g)? 2) If
taxpayer can defer the recognition of gain, what
are his bases in the property retained after the
condemnation and the replacement property?
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Earliest Replacement Date

• Typically, date of involuntary conversion
• Except
• Condemned property - date of threat or imminence
  of requisition or condemnation

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Nonrecognition of Gain

• Direct Conversion
• Nonrecognition of realized gain - mandatory
• Carry over basis
• Rare in practice
• Conversion into Money
• Realized gain - recognized only to extent amount
  realized gt cost of qualifying replacement
  property
• Elective (if election not made, gain
  recognized)

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Conversion into money and replacement

• Basis of replacement property Cost less
  deferred gain
• Holding period tacks
• 1033 only applies to gains - not losses
• Losses from involuntary conversions are
  recognized (if otherwise allowed)

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Test Your Understanding
Ws warehouse, with an adjusted basis of 50,000,
is destroyed by fire in 1997. W is a calendar
year taxpayer. In 1997, W receives an
insurance reimbursement of 100,000 for the loss.
W invests 80,000 in a new warehouse. When must
W invest in the warehouse to postpone gain?
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• What is Ws realized gain?

• Assuming the replacement property qualifies,
  what is
• Ws recognized gain?

• What is Ws basis in the new warehouse?

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Acquisition from Related Parties

• Originally -
• C Corps. Could not defer gain under 1033 if
  replacement property was purchased from a related
  party ( 267 707(b))
• Exception -
• Related party obtained the replacement property
  from unrelated party during the 2 year period
• Also applied to partnerships owned gt50 by C
  corporations

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Acquisition from Related Parties1997 Act

• Expanded the rule
• To all taxpayers
• Provided a deminimus rule of 100,000 total
  realized gain on the converted property

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Summary of 1033

• Applies only to gains - not losses
• Indirect conversions - elective
• Applies to involuntary conversion of all types of
  property
• Some gain may be recognized if replacement is
  less than the amount realized
• Gain is only deferred

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Summary of 1033

• Basis of replacement property is cost less
  deferred gain
• Generally acquired property must be functionally
  related property
• Required replacement period generally begins with
  date of disposition and ends 2 years after the
  close of the first year any part of the gain is
  realized 3 years for condemned real estate