Overview of Tax Consequences of Condemnation of Private Agricultural Lands By Robert Fishman, Fishman, Larsen, Goldring & Zeitler (http://www.flgz.net/) 1 Legal Disclaimer. The information provided below is not legal advice, but rather is only intended as a brief summary of some of the key points relating to the tax consequences of property condemnation under 1033 of Internal Revenue Code (IRC) and other applicable laws. Individuals seeking legal advice on these matters should consult a competent private attorney or tax adviser for guidance on their own particular facts and circumstances. Introduction. Many agricultural landowners are familiar with IRC 1031, which allows them to avoid or reduce costly federal and state taxes by reinvesting proceeds from a sale of farmland in like kind property. A related but less known tax provision is 1033, which deals with eminent domain and government takings of private property ( condemnation or, more technically, an involuntary conversion ). Similar to 1031, 1033 permits deferral of taxable gain by reinvesting in replacement property. But unlike 1031, 1033 allows the taxpayer to keep control of the money received from the condemnation sale of his property for several years before purchasing replacement property. Taxable Gain. Generally, when property is taken by condemnation or sold under threat of condemnation, taxable gain results. Taxable gain is the amount by which the sale price exceeds the Tax Basis of the property. Tax Basis is generally the original purchase price of the property, plus the cost of improvements, less depreciation. This gain can be substantial if the condemned property was purchased or developed decades if not generations ago. Tax Planning. Without careful planning, including timely reinvestment, the taxable gain from a significant difference between the condemnation proceeds and Tax Basis can result in substantial taxes in addition to the loss of property due to the condemnation itself. Fortunately, planning on the sound advice of a competent tax attorney or advisor both before and after a condemnation or sale under a threat of eminent domain can reduce or eliminate the tax cost of involuntary conversions. Purpose of 1033. 1033 is a relief provision enacted to allow taxpayers to replace property involuntarily converted without recognizing gain. 1 Much more information on the subject of tax deferral under IRC 1033 is available at http://flgz.net/sites/default/files/u19/california%20tax%20lawyer%20high-speed-rail.pdf (Fishman, High-Speed Rail: Tax Aspects of Condemnation (2013) 22 Cal. Tax Lawyer 2) and http://flgz.net/1033.pdf (High-Speed Rail: Tax Aspects of Condemnation, 1033 Examples). Page 1 of 7
1033 Deferral. Under 1033, the taxable gain is only deferred, not avoided completely. Similar to 1031, the deferral of taxation under 1033 continues until the replacement property is sold. This deferral could however be permanent if the replacement property is held until the death of the landowner, at which time land obtains a new stepped-up Tax Basis. Basics Of 1033 Calculation of Taxable Amount. Proceeds from a sale of property under threat of condemnation (or receipt of a condemnation award) are treated no differently for tax purposes than a sale of the property. That is, the seller or condemnee is taxed on the difference between the amount received for his property and his Tax Basis. o Example 1. Assume the Tax Basis of the taxpayer s property is $50K and $300K is received as a result of a condemnation award or sale; taxable gain is $250,000, upon which taxes will be owed. But that gain can be deferred if the requirements of 1033 are met. Four Requirements of 1033. The requirements of 1033 are straight forward: a) the property must be sold under threat or imminence of condemnation; b) the taxpayer must elect to be treated under 1033; c) qualified replacement property must be purchased with a price equal or greater than the condemnation proceeds; and d) the replacement property must be purchased within the appropriate replacement period. Threat or Imminence of Condemnation. Sale of the property to either the condemning authority or to a third party will qualify under 1033 if the sale occurs after the condemning authority threatened condemnation. Generally, the taxpayer must, at the time his property was sold, have had reasonable ground to believe that condemnation was threatened or imminent. Electing 1033 Electing 1033 occurs either by: a) simply not reporting the taxable gain from the condemnation or sale on the taxpayer s return for the year of sale, or b) affirmatively reporting the details of the involuntary conversion but not reporting the gain on such return. This election must be made in the first year in which compensation received exceeds Tax Basis in the property. Qualifying Replacement Property Rules As described below, qualifying replacement property must meet one of two tests: Page 2 of 7
o o Similar or Related in Service or Use Test. To meet this test, the sale and replacement property must be of similar service to the seller and generally have the same management and business risks; this test can be difficult to meet. For example, farm equipment replaced with real property, or vice versa, would not qualify. Like Kind Test. Fortunately, if both the sale property and replacement property are real property held for productive use in the taxpayer s trade or business or for investment ( Business Real Property ), meeting the requirements of 1033 is much easier than under similar or related in service or use test. If both the condemned or sale property and the replacement property are Business Real Property, the like kind test should be met. Under the like kind test, farm real property that is to be rented can qualify as replacement property for an actively managed farm that was condemned, as both are used for trade or business or for investment. Even more liberally, an apartment building can qualify as replacement property for a farm that was condemned, as again both are Business Real Property and qualify as like kind under 1033. Residential Property. A single family residence not part of the farm will not qualify under the like kind test, as it is considered personal use property and not used in trade or business or for investment. However, if such a personal residence is condemned, and replaced by a similar home for personal use, it will qualify for 1033 treatment if the two residences are similar or related in service or use. Houses located on the farm and occupied by the farmer s family may, depending on the particular facts, qualify under the like kind test if they are part of the trade or business of farming. Also houses on farm property rented to third parties will qualify under the like-kind test since they are held for productive use in the trade or business or for investment. o Replacement Property Purchased from Related Persons. If the replacement property is acquired from a related person such as a sibling, spouse, parent, or child, it will not qualify as replacement property to the extent gain from the involuntary conversion exceeds $100,000. Out-of-State and Foreign as Replacement Property. For farmland condemned or sold in California, the acquisition of replacement property in other states in the U.S. will qualify under 1033. Although foreign real property cannot qualify as replacement property for purposes of 1031 exchanges, it qualifies as replacement property in involuntary conversions. Thus, if U.S. real property is condemned and the condemnation proceeds are reinvested within the statutory period in foreign Business Real Property (outside of the U.S.), gain on the condemnation qualifies for non-recognition. Replacement Period Page 3 of 7
The replacement period has both a beginning date and ending date. To qualify for deferral of gain under 1033, the replacement property must be acquired after the start of the replacement period, and before it ends. The replacement period begins on the earlier of: a) the date the condemned property is acquired, or b) the date the property is threatened to be acquired by the condemning authority. When the replacement period ends differs depending upon whether or not Business Real Property is involved. If Business Real Property is condemned or sold under threat of condemnation, then the replacement period ends three years from the close of the first taxable year in which any part of the condemnation gain is realized ( 3-Year Period ). 2 In all other cases, the replacement period ends two (2) years after the close of the first taxable year in which any part of the condemnation gain is realized ( 2-Year Period ). o Example 2. Assume Business Real Property such as a farm is sold to the condemning authority on March 1, 2013; the like kind replacement property must be acquired by December 31, 2016 (3-Year Period). In contrast, if a personal residence in town, not part of the ranch (or a business consisting of equipment such as a car wash), is sold to the condemning authority on the same 2013 date, under 1033 the taxpayer has only until December 31, 2015 (2-Year Period) to purchase replacement property (which property must be similar or related in service or use to the condemned property). Special Rules Regarding Real Property Improvements Existing Versus New Improvements On Replacement Property. As stated above, if Business Real Property is condemned or sold under threat of condemnation, the taxpayer has until the last day of the 3-Year Period within which to acquire qualified like kind replacement property. If the replacement property purchased has improvements such as a building, both the land and building will qualify as like kind replacement property. However, if those improvements are constructed on the replacement property after it is purchased, there is contradicting authority as to whether or not those improvements will qualify as like kind replacement property. 2 Note: In a condemnation proceeding, property may have been taken before the total condemnation award is finally determined, and the condemning authority may have made a deposit with the court of an amount it believes is a fair value for the property. If the landowner can withdraw that deposit, he may be in constructive receipt of it for tax purposes. If the amount considered as constructively received is in excess of the Tax Basis of the property, the landowner has realized gain thereby starting the replacement period. It may take years of litigation to finally resolve the total amount of the condemnation award. Thus, the landowner could be in the difficult position of having started the replacement period under 1033 without having all the funds to purchase replacement property. Page 4 of 7
Improvements on Replacement versus Retained or Other Existing Property. In contrast, the law is clear that improvements to retained real property do not qualify as like kind. o Example 3. Assume the taxpayer sold his almond orchard in 2013 under threat of condemnation for $1MM. In this instance, he would have until December 31, 2016 (3- Year Period) to acquire replacement Business Real Property. Suppose the replacement property only cost $700K and the taxpayer, after purchase, planted almonds on the replacement property costing in excess of $300K. There is some authority that the postacquisition $300K in improvements would qualify as like kind property provided those improvements were made within the 3-Year Period. o Example 4. Same facts as Example 3 except that the taxpayer did not purchase replacement property but instead developed almonds on other property he owned. The almond development cost would not be considered as like kind property. But the development cost incurred on or before December 31, 2015 (2-Year Period) would qualify as replacement property if similar or related in service or use to the condemned property. Severance Damages. o Severance damages (as distinct from direct compensation for a taking of property) are amounts paid by the condemning authority for damages to retained (i.e., remaining) portions of a property not taken by the condemning authority. o Severance damages reduce the Tax Basis of the retained and damaged property; taxable gain is recognized only to the extent severance damages exceed such Tax Basis. o Severance damages can be reinvested under 1033 in qualified replacement property in order to defer any taxable gain from being recognized. Crops. If Business Real Property such as a farm has been owned for more than one year and has growing crops at the time it is taken by condemnation or sold under threat of condemnation, then a strong argument can be made that the amount paid for the crop, as well as the land, constitutes real property qualifying for like kind treatment. Trees, Vines, and Irrigation Systems. If a farm has trees, vines, wells, pumps, pipeline and irrigation systems, those improvements are known as 1245 property. If such improved property is condemned, the replacement property must also include 1245 property at a value equal to or greater than the value of the 1245 property of the Page 5 of 7
condemned property, in order to avoid depreciation recapture (ordinary income). The Treasury regulations contain a complex set of rules covering how this allocation must be made. Economic Unit Theory. If only a portion of a farm or ranch is taken by condemnation and as a result the remaining portion of the property becomes no longer economically viable, then under the economic unit theory this remaining portion may be able to be sold to a third party and qualify for 1033 treatment. In such cases replacement property could be acquired to defer the tax under 1033 for both the condemned and noncondemned portion of the farm. Possible Problems With Buying Replacement Property. Where only a portion of the farmer s property is taken by the condemning authority, and he receives very little condemnation proceeds, he may have difficulty being able to purchase replacement property in order to defer the gain under 1033. Example 5. The High Speed Rail Authority ( HSR ) is currently in the process of condemning property for its rail alignment. Suppose only 3 acres of a Landowner s farm is taken by HRS and he is paid $50,000. But the Tax Basis of that portion of his property is $5,000, and therefore his gain realized is $45,000. In order to defer the entire gain, he must purchase qualified replacement property within the replacement period for at least $50,000. Finding replacement property for only $50K could be difficult. But he can buy property for more and defer the gain. Assume he buys qualified replacement property for $250,000. If he purchases that property within the replacement period, the entire $50K in gain would be deferred. Extensions of Replacement Period. Extensions of the replacement period can be obtained from the IRS for good cause. Usually such extensions are only granted for 1 year. Non-Qualified Transactions Under 1033. Circumstances that can cause a condemnation not to qualify under 1033 in whole or in part include: o Failing to purchase replacement property within the statutory period; o The replacement property is not similar or related in service or use or not of like kind ; or o Qualified Replacement Property was timely acquired, but at a lower cost than anticipated. Condemnation and Property Taxes. Normally, when real property is purchased, its assessed value for property tax purposes is its cost. There is a special provision under California Law that allows replacement property resulting from an acquisition by a Page 6 of 7
public entity to qualify for property tax at a lesser assessed value. However, to qualify under this rule, the replacement property must be similar in size, utility and function to the condemned property a far more restrictive test than the like kind rule of 1033. Page 7 of 7