PORTFOLIO

Involuntary Conversions (Portfolio 568)

Tax Management Portfolio, Involuntary Conversions, No. 568-4th, analyzes the tax problems that arise in connection with involuntary conversions resulting from the theft, destruction, seizure, requisition, or condemnation of property. Where property is condemned or is lost through theft, fire, or a similar event and the owner receives compensation for such “involuntarily converted” property, taxable gain normally results to the extent the value of the compensation exceeds the basis of the converted property. Section 1033 is a relief provision that allows the taxpayer to defer the recognition of gain.

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DESCRIPTION

Tax Management Portfolio, Involuntary Conversions, No. 568-4th, analyzes the tax problems that arise in connection with involuntary conversions resulting from the theft, destruction, seizure, requisition, or condemnation of property. Where property is condemned or is lost through theft, fire, or a similar event and the owner receives compensation for such “involuntarily converted” property, taxable gain normally results to the extent the value of the compensation exceeds the basis of the converted property. Section 1033 is a relief provision that allows the taxpayer to defer the recognition of gain.


The basic rules are as follows:


1. Where the taxpayer receives property similar or related in service or use to the involuntarily converted property, no gain is recognized on the involuntary conversion, and the new property takes the same basis as the old property.
2. Where the taxpayer receives cash or other proceeds to compensate him for the involuntary conversion of the property, he may elect not to recognize the gain if he reinvests the proceeds in property that is similar or related in service or use to the converted property. The basis of the new property normally will be the same as the basis of the old property if all the proceeds are reinvested in the new property.


The Portfolio also discusses business interruption insurance and disaster relief payments, gives examples of involuntary conversions, explains the threat or imminence of condemnation, describes similar property, and reviews severance damages, separate awards, and replacement periods. The relationship between the investment credit, accelerated depreciation and recaptures is also discussed.


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AUTHORS

BRUCE N. EDWARDS, ESQ.
Bruce N. Edwards, Esq., B.A., The Colorado College; J.D., University of Washington School of Law; LL.M. (in Taxation), New York University; former Law Clerk to the Honorable Shiro Kashiwa, Associate Judge, the United States Court of Claims (now the Court of Appeals for the Federal Circuit); former New Decisions Editor, The Journal of Taxation; selected as Superlawyer, Washington Law & Politics (2005, 2004, 2003); author, 610-2nd T.M., Timber Transactions (2006); 594-2nd T.M., Tax Implications of Home Ownership (2004); 568-3rd T.M., Involuntary Conversions (1999); “Understanding And Making The New Section 646 Election For Alaska Native Settlement Trusts,” 18 Alaska Law Journal 217 (Duke University 2001); “Understanding and Using ‘Partnership Redemptions' In the Context of Section 1(h),” 45 Tax Management Memorandum No. 19, 1 (Sept. 20, 2004); Tax Practice Series: Chapter 1530, Home Ownership (2004); Chapter 1510, Tax Free Exchanges (2000); Chapter 2650, Taxation of Timber (2000); Chapter 1520, Involuntary Conversions (1998); Chapter 3880, Tax Court Litigation (1998), Chapter 3890, Refund Litigation (1998); Chapter 3850, IRS Audit Procedures (1997); Chapter 3860, Statute of Limitations (1997); member, Washington and Alaska Bars; member, American Bar Association (Section of Taxation, Committee on Court Procedure); member American College of Tax Counsel.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

A. General Rule of Section 1033 - Deferral of Gain

B. Losses on Involuntary Conversions Not Affected by Section 1033

C. Relationship with Section 1231

D. Statutory History of Section 1033

II. What Constitutes an Involuntary Conversion

Introductory Material

A. Theft or Destruction

1. In General

2. Partial Destruction

B. Seizure, Requisition or Condemnation

1. Seizure

2. Requisition or Condemnation

a. In General

b. Inverse Condemnation

3. Effect of Actual Condemnation on Taxpayer's Other Land

a. Receipt of Severance Damages

b. Voluntary Sale of Adjacent or Related Land

c. Special Assessment Against Retained Land

4. Temporary Seizures and Condemnations

C. Threat or Imminence of Condemnation

1. What Constitutes Threat or Imminence

2. Private or Public Sales Permissible

D. Other Deemed Involuntary Conversions

1. Section 1033(c): Reclamation Law Sales

2. Section 1033(d): Destruction of Diseased Livestock

3. Section 1033(e): Livestock Sales on Account of Drought, Flood, or Other Weather-Related Conditions

4. Section 1033(j): Sales to Facilitate Microwave Relocation Policy

5. Section 1033(k): Sales and Exchanges Under Certain Hazard Mitigation Programs

6. Deemed Involuntary Conversions Not Described in Tax Code

E. Former Law: Deemed Involuntary Conversions Under Former § 1071

III. Tax Consequences of Conversions into Similar Property Only: § 1033(a)(1)

A. What Constitutes “Similar Property”

B. Consequences

C. Example

IV. Tax Consequences of Conversion into Dissimilar Property Only: § 1033(a)(2)

A. What Constitutes Dissimilar Property

B. Effect of No Valid § 1033(a)(2) Election

C. Direct Effects of a Valid § 1033(a)(2) Election

D. Examples

E. Potential Problem if Noncash Dissimilar Property Is Received

V. Tax Consequences of Conversion into Both Dissimilar and Similar Property

A. Ambiguous Legal Standards

B. Examples

C. Is Nonrecognition Mandatory?

VI. Making the Various Section 1033 Elections

A. How and When Regular § 1033(a)(2) Election Made: Rev. Rul. 83-39

1. On Return for All Years in Which Proceeds Received

2. Affirmative Statement Not Required, Only Exclusion

3. Changing a Previous Election

a. Revoking a Nonrecognition Election

b. Electing Deferral After Recognition of Gain

4. Particular Details Required for § 1033(c), (d), and (e)

5. Collateral Effects of § 1033(a)(2) Election

B. How and When Former § 1071 Election Made

1. Affirmative Statement Only

2. Amended Return Usually Not Acceptable

a. Cloutier v. U.S.

b. Limited Exception - Park Broadcasting, Inc. v. Comr.

c. Query: Effect of Extension?

3. Nonrevocation of Former § 1071 Election

4. Filing of FCC Certificate

C. Making the § 1033(g)(3) Election

1. General Statement of § 1033(g)(3) Effect

2. When Election Made; Revocation

3. Content of Statement

D. Who Makes a Particular Election

1. Partnership Must Elect

2. S Corporations Must Elect

VII. Making the Section 1033(a)(2) Replacement

Introductory Material

A. Who May Replace

1. General Rule: The Taxpayer

2. Corporations

a. Corporations v. Shareholders

b. Successor Corporate Entities

c. Replacement by Related Corporations

3. Estates

4. Trusts

5. Partnerships

6. Cooperatives

B. Types of Replacement Property

1. Property Similar in Use: Section 1033(a)(1)

a. Requirements for Property Similar in Use

b. Examples of Similar in Use Property

c. Examples of Property Not Similar in Use

d. Examples of Partially Qualified Replacement Property

2. Stock of a Corporation Owning Similar Use Property: Section 1033(a)(2)(A)

a. Acquisition of Control

b. Requirement of Purchase

c. When Similar Use Property Must Be Owned

d. Extent of Similar Use Property

e. Holding Company Stock

f. Purchase of Partnership Interest Compared

g. Basis

3. Property That Is Like-Kind: Section 1033(g)

a. Interaction with the Similar Use Test

b. What Constitutes Like-Kind Property

c. Examples of Like-Kind Replacement

d. Examples of Property That Is Not Like-Kind

e. Trade or Business Use or Investment

f. Outdoor Advertising Displays Treated as Real Property

4. Farm Property Replacing Livestock: Section 1033(f)

C. Replacement Property Must Be Acquired Through Purchase

1. In General

2. Investment in Already Owned Property

3. Purchase from a Related Taxpayer

a. Section 1033(i)

b. Related Party Replacements Not Controlled by § 1033(i)

4. Use of Particular Funds

5. Purchase Through Construction

D. Replacement Property Must Be Acquired to Replace Converted Property

1. In General: Intent to Replace

2. Acquisition/Liquidation Satisfies Intent Requirement

3. Additional Intent for § 1033(g) Replacements

E. When Replacement Must Occur

1. Replacement Through Similar Use Property

2. Replacement Under § 1033(e)

3. Extended Replacement Periods for Certain Property

4. When Replacement Occurs

5. Discretionary Extension by IRS

F. Notification of Replacement or Nonreplacement

G. Consequences of Failure to Replace After Election

H. Special Rule for Acquisitions of Replacement Property by Subsidiary Corporations and Partnerships

VIII. Special Problems and Planning Opportunities

Introductory Material

A. Conversions of Multiple Properties

B. Multiple Replacement Properties

C. Condemnation of Real Property

1. Unimproved Real Estate Replaced by Improved Real Estate

2. Improved Real Estate Replaced by Improved Real Estate

D. Stock Acquisition Versus Asset Acquisition

E. Other Corporate Planning Opportunities

1. Asset Acquisition Followed by Incorporation

2. Incorporation of the Conversion Proceeds

a. Contribution to Subsidiary Already Owning Replacement Properties

b. Incorporation of the Proceeds in a Newly Formed Subsidiary or Existing Affiliated Corporation

3. Defective Split-Up

4. Shelter of § 311(b) Gain

F. Recovery Property - Churning Problem

1. Pre-1986 TRA ACRS

2. Post-1986 TRA ACRS

G. Conversion of Principal Residence

1. Law Applicable to Sales and Exchanges After May 6, 1997

2. General Rule for Residential Conversions Before May 7, 1997: Choice Between § 1034 and § 1033

3. One-time Gain Exclusion for Residential Sales Before May 7, 1997: Section 121

4. Presidentially Declared Disasters as to Residences Before May 7, 1997: Section 1033(h)(1)

H. Interaction with Estate Tax Issues

1. Section 2032A

2. Section 2057

I. Partnership, Limited Liability Company, and Joint Tenancy Planning

J. Obtaining an IRS Ruling

K. Special Issues for Corporations and Partnerships

L. Federally Declared Disasters of Business Property

M. Depreciation of MACRS Property Acquired in an Involuntary Conversion

N. Tax-Exempt Use Property

O. Trust and Estate Replacements

P. State and Local Law Issues

Q. Malpractice Issues

IX. Mortgages and Liens

A. Mortgages and Liens on Converted Property

B. Mortgage on Replacement Property

C. Special Mortgage Problem: Partnership Property

X. Miscellaneous Expenses and Payments

A. Acquisition Costs

B. Conversion Expenses

C. Casualty Loss Expenses

D. Severance Damages and Special Assessments

E. Interest

F. Business Interruption Insurance

G. Reimbursements for Relocation Costs, Living Expenses, and Other Payments

1. Temporary Living Expenses

2. Certain Federal Acquisitions

3. Moving Expenses Reimbursement and Other Payments

4. Statutory Indemnity Payment

H. Tax Benefit Rule

I. Other Impacts of § 1033

J. Lawsuit Settlements

XI. Conversions of Section 1245 and Section 1245 Recovery Property

A. General Rules of § 1245 Recapture

B. Section 1245 and Involuntary Conversions: Section 1245(b)(4)

C. Basis and § 1245 Taint in Replacement

XII. Conversions of Section 1250 Property

A. General Rules of § 1250 Recapture

1. Tier One: Post-1975 Depreciation Recapture

2. Tier Two: Post-1969 and Pre-1976 Depreciation Recapture

B. Section 1250 and Involuntary Conversions: Section 1250(d)(4)

C. Basis and § 1250 Taint in Replacement Property

XIII. Section 1033 and the Rehabilitation Credit


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Client Letter re: Advisability of Deferring Gain on Involuntary Conversion

Worksheet 2 Condemnation Documents/Memoranda

Worksheet 3 Sample Statement Electing Section 1033 Treatment and Identifying Replacement Property

Worksheet 4 Sample Election Statements with Regard to FCC-certified Sales

Worksheet 5 Sample Statement Electing to Treat Outdoor Advertising Displays as Real Property

Worksheet 6 Statement Identifying Replacement Property to Accompany Return for Replacement Year Subsequent to Destruction Year

Worksheet 7 Statement to Accompany Amended Return when Replacement Cost Is Less Than Anticipated and Gain Is Produced

Worksheet 8 Statement to Accompany Refund Claim when Replacement Cost Exceeds Original Estimate and Tax Was Paid on Conversion “Gain”

Worksheet 9 Application for Extension of Time for Replacement of Converted Property

Worksheet 10 Request for Determination Letter on Replacement Property

Bibliography

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Statutes:

Treasury Regulations:

Committee Reports:

Treasury Notices:

Treasury Rulings:

Cases:

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