Internal Revenue Service (IRS)
Revenue Ruling (Rev. Rul.)
26 § CFR 1.1033(c)-1
(Also § 167; 1.167(a)-5.)
Involuntary Conversion; Replacement Property; Land and Building; Basis
Involuntary conversion; replacement property; land and building; basis. A taxpayer who elected not to recognize the gain realized on the involuntary conversion of unimproved land subsequently acquired land and improvements and selected only the land as replacement property. The taxpayer must apply the unrecognized gain to reduce the basis of the replacement property as a unit, and the remaining basis must be allocated to the land and improvements in proportion to their respective costs.
Can the unrecognized gain on an involuntary conversion of unimproved land be applied to reduce only the basis of acquired land and not the improvements on the acquired land if only the land is selected as replacement property under the circumstances described below?
In 1976, unimproved land with a cost basis of 60x dollars that was held for investment by the taxpayer, an individual, was condemned, and 300x dollars was paid to the taxpayer by the condemning authority. In 1977, the taxpayer acquired improved real property for investment at a purchase price of 600x dollars, of which 200x dollars was allocable to the improvements and 400x dollars was allocable to the land. For purposes of section 1033 of the Internal Revenue Code, the taxpayer elected to treat only the land portion of the 1977 acquisition as replacement property for the property condemned in 1976.
Law and Analysis
Section 1033(a)(2) of the Code deals with property that is compulsorily or involuntarily converted into money as a result of condemnation. It provides that if the taxpayer, during the period specified, for the purpose of replacing the property so converted, purchases other property similar or related in service or use to such converted property, gain shall be recognized only to the extent that the amount realized upon such conversion exceeds the cost of the replacement property.
Section 1033(g) of the Code provides that, for purposes of section 1033(a), if real property held for productive use in a trade or business or for investment is, as a result of its condemnation, compulsorily or involuntarily converted, property of a like kind to be held either for productive use in a trade or business or for investment shall be treated as property similar or related in service or use to the property so converted.
Section 1.1033(f)-1(a) of the Income Tax Regulations refers to section 1.1031(a)-1(b) for principles to be used in determining whether the replacement property is property of like kind.
Section 1.1031(a)-1(b) of the regulations provides that the words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Section 1.1031(a)-1(c) states that improved real estate and unimproved real estate are like kind property.
Section 1033(b) of the Code provides that in the case of property purchased by the taxpayer in a transaction described in section 1033(a)(2) that resulted in the nonrecognition of any part of the gain realized as the result of a compulsory or involuntary conversion, the basis shall be the cost of such property decreased in the amount of the gain not so recognized. If the property purchased consists of more than one piece of property, the basis determined shall be allocated to the purchased properties in proportion to their respective costs.
Section 1.167(a)-5 of the regulations provides that in the case of an acquisition of a combination of depreciable and nondepreciable property for a lump sum, the basis for depreciation cannot exceed an amount that bears the same proportion to the lump sum as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time.
Rev. Rul. 73-18, 1973-1 C.B. 368, holds that if the replacement property for improved real property sold under threat of condemnation consists of land and a building, the taxpayer’s basis in the replacement property must be allocated between the land and building in proportion to their respective costs.
In Aschaffenburg v. United States, 381 F.Supp. 510 (E.D. La. 1974), improved real property was involuntarily converted and replaced by the purchase of an interest in other improved property. The taxpayer argued that since the State paid only for the land, the reinvestment of the payment from the State should only be allocated to the land. The court, citing Rev. Rul. 73-18, held that the cost basis of the replacement property is first reduced by the gain not recognized on the involuntary conversion and then allocated between the improvements and the land in accordance with section 1.167(a)-5 of the regulations.
The unrecognized gain (240x dollars) on the involuntary conversion of the unimproved land must be applied to reduce the basis (600x dollars) of the replacement property as a unit, and the remainder must be allocated to the land and improvements in proportion to their respective costs, notwithstanding the fact that the taxpayer elected only the land portion of the 1977 acquisition to be the replacement property for the property condemned. Thus, the basis of the land is 240x dollars (400x-2/3 of unrecognized gain of 240x) and the basis of improvements is 120x dollars (200x-1/3 of unrecognized gain of 240x).