Natural Disasters Can Result in Involuntary Conversions

From Katrina to the Midwest floods, involuntary conversions are becoming very common. See what defines an involuntary conversion and what compensation the taxpayer may receive.

August 7, 2008
Sponsored by BNA Software

by Nancy Faussett, CPA

With the large number of recent natural disasters, from Hurricane Katrina to the flooding in the Midwest, involuntary conversions are becoming more and more common. An involuntary conversion can be due to theft, destruction, seizure, requisition or condemnation.

When property is involuntarily converted, the taxpayer may receive compensation, which can be either in the form of other property or a monetary payment. If the payment received exceeds the basis of the converted property, IRS Code Section 1033 allows the taxpayer to defer the recognition of gain under certain circumstances. While Section 1033 does not apply to losses, deferral of a loss may be allowed by another code section (such as Section 1211, Limitation on Capital Losses).

Recognition vs. Deferral of Gain

The treatment of any gain from an involuntary conversion depends on whether the property is converted into similar property or dissimilar property. If the conversion is an exchange of similar property, non-recognition of any gain is mandatory.

If, however, the property is converted into dissimilar property (usually monetary), the taxpayer may elect to defer any gain as long as qualified replacement property is purchased within a certain predefined period of time. Such an election, however, is only possible if the total proceeds received due to the conversion is reinvested. If only part of the proceeds is reinvested, gain must be recognized to the extent of the funds not reinvested.

The deferral of the gain on an involuntary conversion may actually only be temporary because the basis of the replacement property is reduced by the amount of the gain deferred. If the asset is later disposed, its lowered basis will increase the gain or reduce the loss on the transaction.

Defining Types of Involuntary Conversions

To qualify as an involuntary conversion, the loss of the property must be due to one of the following:

  • Destruction: If property has been destroyed, the destruction does not need to be sudden. Progressive decline in a property's condition can qualify. Causes include pollution, termites, drought and contamination. However, to qualify under Section 1033, the taxpayer must not have been able to avoid or prevent the property's destruction.

    When property is only partially destroyed and the property is subsequently sold, the tax law is more complicated. A lot depends on whether the taxpayer has a choice of keeping the property or selling it. When there is a choice, Section 1033 will not apply. Therefore, when the taxpayer chooses to sell rather than repair the damaged property, the Tax Court will often deny Section 1033 treatment on the basis that for Section 1033 to apply, the circumstances must be completely beyond the taxpayer's control.

  • Theft: Theft includes larceny by false pretenses.
  • Seizure: When a government takes physical possession of property without court approval or without giving the taxpayer compensation, a seizure and involuntary conversion has occurred.
  • Requisition and Condemnation: Under Section 1033, a requisition or condemnation occurs when a governmental authority takes property for public use and the taxpayer must be compensated for the property. However, when compensation is not required (such as when property is condemned as being unfit for human habitation), the event does not qualify for Section 1033 treatment.
  • Threat or Imminence of Condemnation: A sale of property under threat or imminence of condemnation is an involuntary conversion. A condemnation is considered to be threatened or imminent when the taxpayer is given notice that a governmental agency is planning to take the taxpayer's property unless the taxpayer agrees to sell the property voluntarily. Note that the sale does not have to be to the authority threatening the condemnation.

Section 1033 Replacement Property

Correctly acquiring qualifying replacement property is a key element of a Section 1033 involuntary conversion. Qualifying replacement property is:

  • Similar use property,
  • Stock of a corporation owning similar use property,
  • Property of a like-kind if the converted property is real property used in a trade or business (or held for investment) or
  • Farm property if replacing livestock and the involuntary conversion is caused by environmental contamination.

Furthermore, replacement property must be acquired:

  • Through purchase and
  • During the qualifying replacement period.

The qualifying replacement period begins on the earlier of the date of the conversion or the date of the threat, imminence of condemnation or requisition. It generally ends two years after the close of the tax year in which the conversion occurs, although certain extensions have been granted if the taxpayer can show reasonable cause.

Remember that if the Section 1033 property is depreciable property, fixed asset management software can assist you in depreciating both the relinquished property as well as the replacement property and it can provide an audit trail to record the event.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.