Gains & Losses
Taxpayers that own trade or business real property that is involuntarily converted and would like to take advantage of the ability to own a similar investment in a faster growing state or even an emerging market without recognizing the gain from the conversion should consider Sec. 1033.
Sec. 1033(a) covers property that is “compulsorily or involuntarily converted” into similar property or money “as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof.” Sec. 1033(a)(1) provides that a taxpayer can elect to defer the gain on the conversion of such property if the property is replaced by, or the proceeds are reinvested in, similar or related use property. The term “similar or related in service or use” is not defined in the Code or the regulations.
The IRS has at times applied a functional use test where the replaced property would have to have closely similar physical characteristics and uses to the converted property but need not be exactly the same. Over the years the IRS and the courts have expanded this definition. Maloof, 65 T.C. 263 (1975), summarized prior court precedents in stating that
it is clear that the reinvestment must be made in substantially similar business property. Ellis D. Wheeler , 58 T.C. 459, 463 (1972). Stated differently, the statute requires a “reasonably similar continuation of the petitioner’s prior commitment of capital and not a departure from it.” Harvey J. Johnson , 43 T.C. 736, 741 (1965). While it is not necessary to acquire property which duplicates exactly that which was converted ( Loco Realty Co . v. Commissioner , 306 F.2d 207 (8th Cir. 1962), revg. 35 T.C. 1059 (1961)), the fortuitous circumstance of involuntary conversion does not permit a taxpayer to change the character of his investment without tax consequences (see Liant Record, Inc. v. Commissioner , 303 F.2d 326 (2d Cir. 1962), revg. 36 T.C. 224 (1961)). [ Maloo f , 65 T.C. at 269]
The IRS and the courts over the years have provided many examples to guide the taxpayer in meeting the “similar use” criteria.
In order for the taxpayer to qualify for nonrecognition of gain under Sec. 1033(a)(2)(B)(i), the law requires that the replacement property be acquired within two years after the close of the first tax year in which the property was involuntarily converted, while Regs. Sec. 1.1033(a)-2(c)(2) prescribes the exact form and prescription of the taxpayer’s election.
There are special rules dealing with involuntary conversion of real property. Under Sec. 1033(g)(1), real property that was held for productive use in a trade or business or as an investment that is involuntarily converted gives the taxpayer the ability to defer the gain if the property is reinvested in like-kind property instead of similar property. Like-kind property has a broader definition than similar property. Regs. Sec. 1.1031(a)-1(b) provides that properties are of like kind or like class if they are of the same nature or character, even if they differ in grade or quality. Furthermore, Sec. 1033(g)(4) provides for a three-year (instead of two-year) replacement period from the close of the first tax year in which the property was involuntarily converted to be reinvested in either like-kind or similar use replacement property.
If the replacement property is not acquired within the required replacement period, the taxpayer will need to go back and amend its returns (federal and state) for the year of the involuntary conversion and report its gain to the extent not deferred. In addition, interest will be imposed from the original due date of the return.
By deferring the gain, the taxpayer will receive the same basis in the new property that it had in the old property. Under Sec. 1033(b)(1)(A), if the taxpayer purchases qualified property for less than the sale proceeds received from the involuntary conversion, the portion of the gain that was not reinvested will be taxed in the year of conversion. According to Sec. 1033(b), the taxpayer’s basis in the new property will be its basis in the old property plus the portion of the gain that was already taxed and any additional cash paid or liabilities assumed when acquiring the new property. It is important to note that, when the taxpayer eventually sells the property, the deferred gain and any subsequent additional gain will be taxed.
The same rule of nonrecognition cannot automatically be assumed for state taxes. Many states piggyback on the federal statute and do not require the proceeds to be reinvested within the state of sale, while others require the replacement proceeds to be reinvested within their state in order to qualify for nonrecognition.
Oregon is an example of a state that, depending on the facts and circumstances, could require the taxpayer to recognize gain from an involuntary conversion. Under Oregon Revised Statutes Section 316.738, if gain is deferred for federal tax purposes under Sec. 1033 and the acquired property has situs outside the state of Oregon, upon the disposition of the acquired property there will be an addback to Oregon taxable income for the amount of gain originally deferred. Under Oregon Revised Statutes Section 316.738(3), when the acquired property is located outside the state of Oregon, the taxpayer is required to file an annual report with the Oregon Department of Revenue. Under this statute, the DOR leaves itself the ability to implement additional reporting requirements. It is the author’s opinion that after Oregon receives the annual report, it could require taxpayers that are not Oregon residents to add back to Oregon taxable income in the year of sale the gain on the proceeds received from an involuntary conversion that are reinvested outside Oregon. This assumption could take place only if the acquired property is reinvested outside Oregon and the taxpayer terminates its Oregon residency or was never an Oregon resident.
California is an example of a state that allows taxpayers to reinvest their proceeds received outside the state and still receive the benefits of Sec. 1033. California incorporates most of the federal Code provisions governing the computation of federal adjusted gross income unless a specific provision requires additions or subtractions when computing California adjusted gross income. Sections 18031 and 18038 of the California Revenue and Taxation Code provide that no adjustments are necessary when dealing with Sec. 1033. Therefore, California does not require the gain to be recognized in the year of involuntary conversion when the proceeds are reinvested outside California as long as all the federal rules regarding Sec. 1033 are adhered to.
Example: Taxpayer A owns a nonresidential rental property in Cupertino, CA, that he has owned since 1950, with a basis of $250,000 and a fair market value of $1 million. The government seizes the property through eminent domain in 2010, and A receives $1 million for his property. Due to A ’ s perception of a lack of economic growth in California, he decides to own a like-kind investment in a more attractive state without having to pay tax on his property’s appreciation.
If A sells the property, he will have gain of $750,000, disregarding any special tax treatment under Sec. 1250; with an assumed federal and state tax of 25% on long-term capital gains, he will owe $187,500. After tax, A will have only $812,500 to invest into the new property. If A elects nonrecognition of gain under Sec. 1033(g), he will not owe any tax on the date of involuntary conversion as long as the proceeds are reinvested within three years from the close of the tax year in which the property is involuntarily converted. This would allow A to invest the entire $1 million into his new property and have a carryover basis in his property.
In the example, when the property is eventually disposed of, the original gain will have to be sourced back to California; in the author’s view, any subsequent appreciation will be sourced to the state where the new property was acquired. The amount of gain sourced to California will be the difference between the proceeds received from the involuntary conversion less the taxpayer’s original basis in the property. It is the author’s assumption that the gain sourced to the new state will be the proceeds received from the sale of property less the original basis (as adjusted for subsequent depreciation) plus any amount of gain sourced and recognized to California.
Apparently, Sec. 1033(g) applies even if the replacement property is real property held abroad. Sec. 1031(h) provides that property held within the United States is not like-kind to property held outside the United States. According to the conference committee report for the Omnibus Budget Reconciliation Act of 1989, P.L. 101-239 (H.R. Conf. Rep’t No. 386, 101st Cong., 1st Sess. 614 (11/21/89)), this rule falls outside the grasp of Sec. 1033(g), and taxpayers are allowed to purchase like-kind replacement property located outside the United States and still qualify for Sec. 1033(g) treatment.
With the uncertainty in upcoming federal and state tax rates and the 3.8% Medicare tax that will go into effect January 1, 2013, on all unearned investment income (including capital gains), it is worth considering the merit of paying the taxes on the gain today and getting a step-up in basis in real property. This all depends on how long the taxpayer plans on holding the new property, giving due consideration to the time value of money retained over the holding period versus any anticipated and planned tax increases on the taxpayer’s investment.
An involuntary conversion can take place at any time and without warning. Practitioners and their clients need to look at all the facts and circumstances in order to take full advantage of the special tax saving and investment opportunities that are available to taxpayers when their property is involuntarily converted.
EditorNotes
Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
