Internal Revenue Service (IRS)
Revenue Ruling (Rev. Rul.)
26 USC § 1031; 26 CFR § 1.1031(a)-1
26 USC § 1033; 26 CFR § 1.1033(g)-1
Published: May 21, 1983
Involuntary Conversion; Severance Damages; Condemnation Award
Involuntary conversion; severance damages; condemnation award. Severance damages received as part of a condemnation award for a portion of the taxpayer’s property may be accorded nonrecognition treatment under section 1033(g)(1) of the Code even though the taxpayer reinvests the severance damages in property that is not similar or related in use to the condemned property.
Rev. Ruls. 271 and 80-184 modified.
1) Under the circumstances described below, can a taxpayer defer the recognition of gain realized from “severance damages” received as part of a condemnation award by reinvesting in like-kind property under section 1033(g) of the Internal Revenue Code?
2) If the taxpayer can defer the recognition of gain, what are the taxpayer’s bases in the property retained after the condemnation and the replacement property?
The taxpayer purchased agricultural land and buildings to be held for investment purposes for 220x dollars. The taxpayer then leased the property to a farmer. Prior to expiration of the lease, a portion of the property was condemned by state X to make way for an interstate highway. The remaining property was not adequate to sustain a profitable farming operation. The taxpayer received 175x dollars from state X for the property actually taken and additional damages of 135x dollars for the reduction in value of the retained property. Damages in addition to an award paid for the property actually condemned, when the value of the retained property has decreased as a result of the condemnation, are called “severance damages.” A proper allocation of the taxpayer’s basis in the property was 140x dollars to the portion actually taken and 80x dollars to the remaining portion. Therefore, a gain of 35x dollars was realized on the property actually taken, and a gain of 55x dollars was realized on the remaining portion.
Without making an effort either to restore the utility of the retained property or to locate property in the same area as the condemned property, the taxpayer, within the prescribed period of time set forth in section 1033 of the Internal Revenue Code, purchased for 350x dollars a large motel complex occupying an acre of ground in a city some distance from the former property’s location. The taxpayer actively managed and directly operated the motel for its own account.
Law and Analysis
Section 1033(a)(2) of the Code provides that if property, as a result of a condemnation, is compulsorily or involuntarily converted into money, the gain (if any) shall be recognized, except to the extent provided in section 1033(a)(2)(A).
Section 1033(a)(2)(A) of the Code provides that if during a specified period the taxpayer purchases other properties similar or related in service or use to the property so converted, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized on the conversion exceeds the cost of such other 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), which 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.
Section 1033(g)(1) of the Code provides that for purposes of section 1033(a), if real property held for productive use in trade or business or for investment is (as the result of its seizure, requisition, or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted, property of a like kind to be held for either productive use in 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(g)-1(a) of the Income Tax Regulations provides that the principles set forth in section 1.103(a)-1(b) of the regulations should be followed in determining whether property is of a like kind for purposes of section 1033(g) of the Code.
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 its grade or quality. The fact that real estate is improved or unimproved is not material, for that fact relates only to the grade of the property and not to its kind or class.
Section 1.1031(a)-1(a) of the regulations, applying the principles of section 1.1031(a)-1(b), states that property held for productive use in trade or business may replace property held for investment.
Section 1.1031(a)-1(c)(2) of the regulations, also applying the principles of section 1.1031(a)-1(b), provides that a taxpayer who is not a dealer in real estate may exchange city real estate for a ranch or farm.
Rev. Rul. 68-37, 1968-1 C.B. 359, provides that an award of severange damages reduces the basis of the damaged portion of the retained property and any amount received in excess of basis of such portion is treated as gain.
Rev. Rul. 60-240, 1969-1 C.B. 199, holds that gain resulting from receipt of severance damages for farm land may qualify for nonrecognition when the severance damages are expended to acquire farm land adjacent to the remaining property to permit continuation of farming operations as before the condemnation.
Rev. Rul. 72-433, 1972-2 C.B. 470, holds that proceeds received under a threat of condemnation in return for flowage easement rights on a farm that are reinvested in other farm land qualify for nonrecognition of gain under section 1033 of the Code. In reaching this holding the revenue ruling states that there is a close similarity between the nature of proceeds from the involuntary grant of an easement and the severance damages for the loss in value of retained land resulting from a condemnation. The revenue ruling notes that in both situations a property owner retains property that has been affected in some way by the condemnation of related property.
In Rev. Rul. 72-549, 1972-2 C.B. 472, the taxpayer, under threat of condemnation, granted an electric power company an easement and right-of-way over property used in the taxpayer’s trade or business. The facts indicate that the property involved was unimproved real property. Subsequently, the taxpayer purchased, for an amount in excess of the amount received from the power company, real property with nominal rental improvements and real property with an apartment building. Both properties were held either for productive use in the trade or business or for investment by the taxpayer. The revenue ruling concludes that the easement and right-of-way that the taxpayer granted and the real estate properties that the taxpayer acquired are both continuing interests in real property and of the same nature and character, and as such qualify as “like kind” property under sections 1031 and 1033(g) of the Code. Thus, both properties acquired by the taxpayer qualify as replacement property for purposes of section 1033.
In McShain v. Commissioner, 68 T.C. 154 (1977), the taxpayer received a condemnation award and elected to replace the condemned property with like kind property. Subsequently, upon realizing that for federal income tax purposes it was not advantageous to defer recognition of the gain, the taxpayer sought to revoke a prior election under section 1033 of the Code by contending that the replacement property was not a valid replacement for the condemned property. The condemned property was originally unimproved realty leased by the taxpayer. While title to improvements erected by the lessee passed to the taxpayer upon expiration of the lease, the taxpayer’s investment in the condemned property remained a passive one in which the taxpayer had no major obligation or duties. In contrast, the replacement property was a motor inn constructed, actively managed, and directly operated by the taxpayer. The taxpayer argued that the replacement property was not “similar or related in service or use” to the condemned property within the meaning of section 1033(a)(2)(A), and the Internal Revenue Service did not contest this point. Rather, the Service asserted that nonrecognition was authorized because the replacement property was “like kind” property within the meaning of section 1033(g). The court concluded that the taxpayer had replaced the condemned property with like kind property noting that, under the regulations, property held for investment may be exchanged for property held for productive use in trade or business.
Rev. Rul. 72-433 indicates that severance damages and proceeds received for the involuntary grant of an easement should be treated the same for federal income tax purposes. In Rev. Rul. 72-549, nonrecognition under section 1033(g) of the Code was afforded to a taxpayer that invested the proceeds received for the granting of an easement over unimproved real property in improved real property. Similarly, section 1033(g) can be utilized to afford relief in the severance damages context of the present case. McShain is illustrative of the less stringent “like kind” test under section 1033(g). The present case is similar to Rev. Rul. 72-549 and McShain. Like the taxpayers in those situations, the taxpayer in the present case invested proceeds realized as a result of a condemnation in property not similar or related in service or use to the condemned property. However, the taxpayer’s investment of the proceeds realized from the condemnation of agricultural property held as a passive investment in an urban motel complex, actively managed and operated by the taxpayer, constitutes a continuing interest in real property. Since the replacement property is of the same nature as the condemned property, within the meaning of section 1.1031(a)-1(b) of the regulations, and is held by the taxpayer for investment or productive use in a trade or business, the replacement property qualifies as property of a like kind within the meaning of section 1033(g).
1) The taxpayer may elect to defer recognition of gain realized from the severance damages received as a part of a condemnation award.
2) The basis of the remaining portion of the original property is zero. If the taxpayer elects to have its gain deferred the basis of the replacement property is, under section 1033(b) of the Code, 260x dollars, representing the cost of the property (350x dollars) reduced by the amount of gain (90x dollars) not recognized.
Effect on Other Revenue Rulings
Rev. Rul. 271, 1953-2 C.B. 36, holds that gain resulting from receipt of severance damages qualifies for nonrecognition under the predecessor of section 1033 of the Code when the severance damages are used to restore the retained property to its former condition. The revenue ruling also provides that gain will be recognized to the extent that the unexpected portion of such damages exceeds the basis of the retained property. To the extent that it holds that only the unexpended portion of severance damages are applied to reduce a taxpayer’s basis in the remaining portion of the original property, Rev. Rul. 271 is modified.
Rev. Rul. 80-184, 1980-2 C.B. 232, to the extent it implies that the nonrecognition provisions of section 1033 of the Code would not apply where severance damages are expended to acquire new property unless there were a showing that it was not economically feasible or practical to invest any more funds in the retained property, is modified.