A Quick Refresher on the Tax Consequences of Condemnation

by Nossaman LLP

Most of us are at least vaguely familiar with the tax on gains from the sale of property.  Many of us know that when property is sold voluntarily and the funds re-invested, the gain may be deferred under Internal Revenue Code section 1031.  What is sometimes overlooked is the taxability of gains when property is sold involuntarily, i.e., condemned.  As we posted several years ago, Internal Revenue Code section 1033 contemplates just such a situation, and provides some advantages over a section 1031 exchange: An owner has more time to re-invest and may actually hold the proceeds pending that investment – no intermediary needed.  (Unlike some other Code provisions, sections 1031 and 1033 do not eliminate gain; rather, they defer gain by allowing the taxpayer to move “built-in” gain from an old property to a new property.)

When Does Section 1033 Apply?

So, when can a property owner facing condemnation take advantage of section 1033?  As one might expect with the tax code, there are a few rules, including:

  • The property must be condemned (i.e., there must be a lawsuit filed) or there must be a “threat or imminence” of condemnation;
  • The property must be replaced within a specified period (usually within 2-3 years)
  • The property must be replaced with eligible property (these are similar to the “like-kind” requirements of section 1031);
  • If, as usually happens in condemnations, the owner receives money first, the owner must elect to treat any gains under section 1033.

And if you’re a taxpayer seeking a deferral of gain in California, you should be aware of federal-California difference that might affect you.  While section 1033 can apply regardless of the nature of the condemning entity, for Proposition 13 purposes, in California the condemnation must be by a public entity, not a private entity with the power of eminent domain.  (For a discussion of why this rule doesn’t make sense and should be changed, see my colleague Brad Kuhn’s post on Prop 13 base value transfer.)

Who Should Care About Section 1033?

Obviously, property owners whose property may be taken for a public use — and their attorneys — should be aware of the advantages of section 1033.  Owners should also pay particular attention to the “threat or imminence” of condemnation requirement.  It is not enough that the property is merely being considered for acquisition, or that an owner is negotiating with a public entity.

Condemning authorities and their consultants should also realize the benefits section 1033 may offer during the negotiation process.  Educating a property owner about the tax consequences of a sale may mean the difference between reaching an early deal and having to proceed to court.

What Happens if Only Part of Property is Condemned?

A large number of condemnations involve only a portion of the property, for example, a strip of frontage for a street widening.  How does section 1033 benefit the owner of the remaining property?  In the case of a part-take, a property owner may be entitled to severance damages – the difference, if any, between the value of the remaining property before and after the condemnation.  The award of severance damages is applied first against and reduces the taxpayer’s “basis” in the remaining property (generally, original purchase price plus the cost of improvements, minus depreciation) and is not taxable to that extent.  Any damages leftover are taxable unless the taxpayer uses section 1033 to restore the remainder or invest in eligible replacement property.

Well, there you have it, my quick summary of section 1033.  I’m sure my colleagues here who are more familiar with tax law (I’m an eminent domain attorney, not a tax attorney) can delve into the specifics.  Together we can guide both owners and agency folks so everyone can maximize their benefits under section 1033.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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