Natural disasters such as hurricanes, tornadoes, and wildfires destroy many homes. Accidental fires destroy additional homes each year. Individuals may also lose their homes to condemnation by a governmental body under the power of eminent domain. The homeowner often receives payment from an insurance company when a casualty destroys a principal residence or compensation from a governmental body for a condemned home. Receiving payment for a principal residence destroyed by a casualty or condemned by a governmental body is an involuntary conversion. Tax professionals should understand the tax consequences of an involuntary conversion of a taxpayer's principal residence to be able to advise their clients properly.
Homeowners may be able to use two provisions to avoid or defer paying tax on all or part of a gain realized on the involuntary conversion of a principal residence. Under Sec. 121, a taxpayer may exclude a certain amount of gain on the sale or exchange of a principal residence if the taxpayer meets the ownership and use tests.1 Under Sec. 1033, on an involuntary conversion of a principal residence, the taxpayer may be able to defer any gain realized by replacing it with a different home within a specified time.2 This article explains both provisions and describes the conditions under which a taxpayer may use the gain deferral provision of Sec. 1033, as well as its interplay with the Sec. 121 exclusion. Lastly, this article explains the rules regarding a casualty loss on a principal residence.
Sec. 121 exclusion
In general, a taxpayer must include all realized gains in gross income.3 One commonly used exception allows individuals to exclude a gain of up to $250,000 ($500,000 if married filing a joint return) from their gross income on the sale or exchange of their principal residence.4 Any remaining gain would be a long-term capital gain.5 If the taxpayer excludes gain under Sec. 121, the taxpayer does not adjust the basis of any new home acquired due to the exclusion. To use the exclusion, the taxpayer must have owned the home and used it as a principal residence for a period of, or periods totaling, two years or more within the five years before the sale or exchange.6 The periods of ownership and use do not have to be concurrent.7
If the ownership and use tests are not met, the taxpayer may qualify for a reduced maximum exclusion in certain circumstances.8 The circumstances outlined in Sec. 121 include a sale by reason of a change in employment or health or due to unforeseen circumstances.9 An involuntary conversion is one of a number of unforeseeable events that allow for a reduced maximum exclusion.10 The reduced maximum exclusion equals $250,000 ($500,000 on a joint return) multiplied by the number of months (or days) of ownership and usage as a principal residence divided by 24 months (or 730 days). Example 1 illustrates the calculation of the reduced maximum exclusion.
Example 1: A, a single individual, owned and lived in a residence for six months until its destruction on Dec. 1 by flood. The maximum exclusion under Sec. 121 would be $62,500 ([6 ÷ 24] × $250,000). Or, in terms of days of a continuous period beginning on June 1: (183 ÷ 730) × $250,000 = $62,671.
Home owned jointly by unmarried individuals
If two unmarried individuals own a home jointly and each individual uses it as a principal residence, then each owner may exclude up to $250,000 of realized gain if each owner meets all other requirements.11 Example 2 illustrates an involuntary conversion of a principal residence owned by two unmarried individuals.
Example 2: B and C are brothers. Neither is married. They bought a home 20 years ago as tenants in common for $130,000 ($100,000 for the home and $30,000 for the land). B and C have used the home exclusively as their principal residence. During the current year, a tornado completely destroyed their home. The home had appreciated in value. They received $400,000 from an insurance company for the destruction of their home. They plan to build a new home on the same land. They realized a gain of $300,000 ($400,000 − $100,000), or $150,000 each, on the involuntary conversion of their home. They meet the ownership and use tests. Each of them may exclude the $150,000 gain from his gross income.
Houseboats, house trailers, and apartments
A houseboat or house trailer, or an apartment the taxpayer is allowed to occupy as a tenant and stockholder in a cooperative housing corporation, may qualify as a principal residence. The exclusion does not apply to any gain realized on any personal property in the residence unless the personal property is a fixture under local law.12 The exclusion does not apply to vacation homes, and the exclusion is not available to certain expatriates.13
Two or more homes
If a taxpayer owns two or more homes, determining which one is the principal residence depends on all the facts and circumstances. The home where the taxpayer spends the most time is generally the principal residence. Other factors to consider include the taxpayer's place of employment, the principal home where family members live, the address shown on tax returns and other government documents, the taxpayer's mailing address for bills, the location of the taxpayer's banks, and the location of religious organizations and recreational clubs with which the taxpayer is affiliated.14
On a joint return, the $500,000 exclusion applies if (1) either spouse has owned the home for at least two of the previous five years before its sale; (2) both spouses have used the home as a principal residence for at least two of the five years before its sale; and (3) neither spouse has used the exclusion for a home sold within two years of the date of the sale of the current home.15
If the couple file a joint return and do not meet all of these requirements, then the requirements apply to each spouse as though the spouse were a single individual, for this purpose only. However, the law deems both spouses to have owned the home during the period that either of them owned it.16
Short, temporary absences
Short, temporary absences do not reduce the time the taxpayer has used the home as a principal residence.17 A taxpayer may rent the home to a tenant during a short, temporary absence without reducing the time the law considers the taxpayer to have occupied the home. A one-year absence to work elsewhere, such as that of a college professor on a sabbatical, is not a short, temporary absence.18 Leaving the home for a two-month vacation every year is a short, temporary absence. The law considers such vacations as periods of use of the home as a principal residence.19
The regulations do not address any period of absence longer than two months and shorter than one year. However, for the purpose of deducting travel expenses while away from a taxpayer's tax home temporarily, the law treats any period up to one year as being away from home overnight on a temporary basis.20While being away from the home for up to one year might be a temporary absence, that does not also mean that it is a short absence.
A vacation or seasonal absence is a short, temporary absence.21 A season lasts for about three months, therefore any absence longer than three months may run a serious risk of the IRS's not treating it as a short, temporary absence.
If a surviving spouse sells a property within two years from the date of death of the deceased spouse, the law increases the $250,000 exclusion to $500,000, so long as the following conditions apply:
- Immediately before the date of death, either spouse owned the home for at least two of the previous five years before death;
- Both spouses used the home as a principal residence for at least two of the five years before death;
- Neither spouse had used the exclusion for a home sold within two years prior to the date of death;22 and
- The surviving spouse must not be remarried at the time of the sale.23
Grantor trusts and LLCs
If a grantor trust owns a home, the law deems the grantor to be the owner of the home for purposes of the Sec. 121 exclusion. If a grantor trust owns a home and an individual (or married couple) is either the owner of the trust or the owner of the part of the trust that includes the home, the grantor is the owner of the residence for purposes of the ownership test. Therefore, the law considers the involuntary conversion of the residence while such a grantor trust owns it as a sale by the taxpayer.24
If a limited liability company (LLC) with only one member and taxed as a disregarded entity owns the residence, it can qualify as the LLC member's principal residence for purposes of the ownership test. The law also treats such a residence as sold by the taxpayer upon its involuntary conversion.25
A taxpayer who owns a home might become incapable of self-care and move to a nursing home or similar facility. A different ownership-and-use test applies to the taxpayer for the Sec. 121 exclusion while the taxpayer is in such a facility: The taxpayer must have owned and used the residence as a principal residence for at least one year during the five years before the sale or exchange or involuntary conversion.26In that case, the taxpayer will be treated as using the property as his or her principal residence during any time in that five-year period that he or she owns the property and resides in a nursing home or similar facility.
Exclusion for casualty gain
A casualty gain on a principal residence may qualify for the Sec. 121 exclusion if the casualty results in the complete destruction of the residence.27 A casualty gain on a principal residence can result where the residence is destroyed because of fire, storm, shipwreck, or other casualty.28 The determination of whether the complete destruction of a residence has occurred is a question of fact. As a practical matter, if the cost to repair a damaged home greatly exceeds its fair market value (FMV) before the casualty, the home may have sustained a complete destruction.29 If a casualty completely destroys the principal residence, the taxpayer may also, within two years of the date of the involuntary conversion, apply any remaining exclusion to the sale of the vacant land on which the destroyed home sat.30 The law treats the sale of the house because of the involuntary conversion and the subsequent sale of the land on which it sat as one sale.31 Example 3 illustrates the sale of land after an involuntary conversion of a principal residence.
Example 3: D, a single taxpayer, owned a house destroyed in a fire. D had a basis in the land and house of $240,000 ($40,000 for the land and $200,000 for the house). On the date of the fire, the house had an FMV of $450,000, and the land had an FMV of $100,000. D's insurance company paid D $450,000 for the destruction of the house. D decided to purchase a home in a different part of the same city. D sold the land three months after the fire for $101,000. D elects to apply the Sec. 121 exclusion to the involuntary conversion and to the sale of the land. Because the law treats them as one sale, D's amount realized is $551,000 ($450,000 + $101,000). D's gain realized is $311,000 ($551,000 − $240,000). He excludes $250,000 of the $311,000 gain realized.
Electing out of the exclusion
If the gain on the sale or exchange or involuntary conversion of the taxpayer's principal residence qualifies for the exclusion, the taxpayer may elect for the exclusion not to apply.32 A taxpayer might want to elect out of the Sec. 121 exclusion and instead elect to defer all of the gain realized as an involuntary conversion.
Electing out of the exclusion might be desirable when the gain is small and the taxpayer plans to buy or construct a new home that costs more than the amount realized on the involuntary conversion. The taxpayer could defer all of the gain and use the exclusion on a later sale.
This election out of the exclusion would be especially desirable if the taxpayer expects property values to increase substantially in the next two years and the taxpayer expects to sell the home shortly thereafter, because the taxpayer may use the benefits of the exclusion only once every two years.33
An involuntary conversion of a home can occur due to seizure or condemnation by a unit of government or by casualty. For a casualty, the destruction of the home must be complete to qualify for exclusion of gain under Sec. 121.34 An involuntary conversion may be either direct or indirect. A direct involuntary conversion occurs when the property is converted into similar property by receipt of a replacement property.35 An indirect involuntary conversion occurs when the taxpayer receives money, debt relief, or other dissimilar property for the converted property.36
A taxpayer treats an involuntary conversion of a principal residence as a sale for the purpose of the exclusion.37 If a taxpayer elects to exclude gain under Sec. 121 on the involuntary conversion of the home, the taxpayer may defer any remaining gain using the involuntary conversion provisions. If the taxpayer uses both provisions, the taxpayer reduces the amount realized on the involuntary conversion by the amount of the gain excluded from gross income under Sec. 121.38 Although the taxpayer does not make a basis adjustment for any gain excluded under Sec. 121, the taxpayer must reduce the basis in a new home for any gain deferred under Sec. 1033 through an involuntary conversion.39 If the taxpayer defers any gain by acquiring or constructing another home after the involuntary conversion, the holding period and use of the new home includes the holding period and use of the home involuntarily converted.40 Example 4 illustrates the use of the exclusion and the deferral of gain on the involuntary conversion of a principal residence.
Example 4: E, a single individual, has owned and lived in the same house for 10 years. E has a basis in the house of $150,000. A fire completely destroys E's house. E's insurance company pays E $550,000. E's gain realized is $400,000 ($550,000 − $150,000). E elects to use Sec. 121 to exclude $250,000 of the gain on the involuntary conversion of the principal residence. Therefore, E's amount realized after consideration of Sec. 121 is $300,000 ($550,000 − $250,000). E's gain realized is $150,000 ($300,000 − $150,000). If E elects to use Sec. 1033 and purchases a replacement property at a cost of at least the amount realized of $300,000, E will be able to defer all of the gain realized on the involuntary conversion. However, if E purchases a home at a cost of $200,000, E would recognize a gain of $100,000 ($300,000 − $200,000). The remaining gain of $50,000 is deferred under Sec. 1033, but E must reduce the basis in the replacement property by the $50,000 deferred gain.
Imminent threat of condemnation
A sale made because of a threat or imminence of a condemnation qualifies as an involuntary conversion.41 The threat of condemnation does not have to come from the condemning authority, but the taxpayer must know the identity of the condemning authority. If the taxpayer does not know the identity of the condemning authority, a sale pursuant to such a threat does not qualify for deferral as an involuntary conversion.
An oral threat is valid if the likelihood of the condemnation is reasonable. Good practice dictates obtaining written confirmation of the threat. A public utility may threaten to persuade a specified governmental entity to condemn the property under the power of eminent domain. If reasonable, such a threat constitutes an imminent threat of condemnation for purposes of the involuntary conversion rules.42 Example 5 illustrates the imminent threat of a condemnation of property under the power of eminent domain.
Example 5: F, a single individual, owns a residence on five acres. The local government (the condemning authority) wants to build a highway over part of the acreage. A representative of the local government threatens to condemn the property under the power of eminent domain if F does not voluntarily sell it to the local government. The representative of the local government notifies F before the sale that it represents the local government condemning authority. F sells the home and acreage after the representative of the local government notifies F of the local government's authority to condemn the property.
Direct involuntary conversion
A direct involuntary conversion of a principal residence occurs when a taxpayer's property is destroyed or condemned and the taxpayer receives a replacement property directly rather than money. With a direct involuntary conversion, a taxpayer does not recognize a gain.43 The taxpayer may not elect out of the deferral of the gain. The basis of the property received will be the same as the property involuntarily converted.44
On a direct involuntary conversion of business or investment property, a taxpayer may recognize a loss.45However, because a principal residence is not business or investment property, the only loss a taxpayer may recognize is the limited loss allowed for a personal casualty loss.46 Example 6 illustrates a direct involuntary conversion of a principal residence.
Example 6: G and H are married and file a joint return. A fire completely destroyed their principal residence. They were insured, but the insurance company paid them no cash. Instead, the insurance company paid a contractor $1,230,000 to build a new home on their lot. The new home has an FMV of $1,230,000. The old home had an adjusted basis of $290,000. The FMVs of the new home and old home exclude the value and adjusted basis of the land. Thus, G and H realize a gain of $940,000 ($1,230,000 − $290,000).47
Sec. 121(d)(5)(A) treats an involuntary conversion of a home, including a condemnation, as a sale of the home for purposes of the Sec. 121 exclusion. Thus, G and H may use the Sec. 121 exclusion of up to $500,000.48 They elect to exclude $500,000 of the gain under Sec. 121. They must defer the remaining gain of $440,000 under Sec. 1033(a)(1). Because nonrecognition of gain for purposes of Sec. 1033 is mandatory on a direct involuntary conversion, the taxpayers do not have to make a Sec. 1033 election to defer gain. For purposes of the Sec. 1033 deferral, the amount realized is the amount determined under Sec. 1001 without regard to the Sec. 121 exclusion, and then reduced by the amount of the exclusion.49 Thus, their amount realized for purposes of Sec. 1033 is $730,000 ($1,230,000 − $500,000). Their gain realized for purposes of Sec. 1033 is $440,000 ($730,000 − $290,000). The law deems the taxpayers to have owned their new home from the date they acquired their old home.50 G and H have an adjusted basis in their new home of $790,000 ($1,230,000 − $440,000 deferred gain, or $290,000 adjusted basis in their old home, plus the $500,000 gain excluded).51
Because the taxpayer must determine the basis of the new home by reference to the basis of the old home, the holding period of the old home tacks onto the holding period of the new home.52 Thus, the law deems them to have owned the new home and used it as a principal residence for as long as they owned the old home.53
Indirect involuntary conversion
An indirect involuntary conversion is more common than a direct involuntary conversion. In an indirect involuntary conversion, a taxpayer receives cash rather than directly receiving new, similar property. The cash usually comes from an insurance company, but it could come from a government agency or from a judgment against a tortfeasor.
A taxpayer recognizes any gain realized on an involuntary conversion unless the taxpayer purchases similar property within the time allowed and elects not to recognize the gain. The time allowed to purchase similar property is generally two years from the end of the tax year in which the taxpayer realized the gain.54 The IRS may allow more time if the taxpayer requests it.55 If the taxpayer makes the election, the taxpayer must recognize the lesser of (1) the gain realized or (2) the excess of the amount realized over the cost of eligible replacement property purchased within the time allowed.56 Example 7 illustrates the use of the Sec. 1033 deferral of gain and the election out of the Sec. 121 exclusion.
Example 7: K, a single individual, has owned and lived in the same house for 10 years. K has a basis in the home of $150,000. A fire completely destroyed the home. K's insurance company paid K $550,000. The gain realized is $400,000 ($550,000 − $150,000). K elects not to use the Sec. 121 exclusion. If K elects to defer gain under Sec. 1033 and purchases a replacement property that costs at least $550,000, K may defer all of the gain realized. However, K purchases a qualified replacement home for $250,000. K must recognize $300,000 of the $400,000 gain realized (the lesser of the $400,000 gain realized or the $300,000 excess of the $550,000 amount realized over the $250,000 cost of the new home). K defers the remaining gain of $100,000 ($400,000 − $300,000) under Sec. 1033, but K must reduce the basis in the replacement property to $150,000 ($250,000 cost of the new home − $100,000 deferred gain).
Usually, a taxpayer may not recognize a loss on the sale or exchange of a principal residence57 because the taxpayer did not use it in a trade or business58 or for the production of income.59 However, a taxpayer may be able to recognize a loss on an involuntary conversion of a principal residence because of a casualty.60 The recognition of a casualty loss for property held for personal purposes is subject to a reduction of $100 per event61 and a reduction of 10% of adjusted gross income (AGI) for all casualty and theft losses recognized during the year.62 In addition, effective Jan. 1, 2018, through Dec. 31, 2025, an individual may deduct casualty losses in excess of casualty gains only if they are due to a federally declared disaster.63 Example 8 shows the tax treatment of a casualty loss on a principal residence.
Example 8: L, a single individual, purchased a principal residence 12 years ago. L's basis in the home was $185,000, which excluded the cost of the land. In 2018, a tornado completely destroyed the home. The tornado was a federally declared disaster, as defined by Sec. 165(i)(5). The FMV of L's home was $200,000 at the time of the tornado. L's insurance company paid L $160,000 to settle the claim. L realized a loss of $25,000 ($160,000 − $185,000). L must subtract $100 from this loss, which leaves L with a loss of $24,900. L's AGI for 2018 is $100,000. L may deduct $14,900 ($24,900 − $10,000) as an itemized deduction. L pays $220,000 to construct a new home on the same lot. The basis of the new home is its cost of $220,000.64 L's holding period for the home begins on the date its construction is complete.
Damage to a principal residence from a casualty that does not completely destroy the home is subject to the same rules. The amount of the loss is the cost to repair the damage, minus any reimbursement received. The taxpayer then subtracts the $100 floor. The taxpayer must reduce the total deduction for casualty and theft losses by 10% of AGI.
Federally declared disaster area
If an involuntary conversion of a taxpayer's principal residence occurs in a federally declared disaster area, the taxpayer has four years from the end of the tax year to replace the residence to defer the gain.65 Example 9 illustrates this replacement period.
Example 9. A hurricane destroyed M's home on Aug. 16, 20X1. M received $252,000 in insurance proceeds for the loss of the home. M's adjusted basis in the home was $227,000, so M realized a gain of $25,000 on the involuntary conversion of the home. The home was in a federally declared disaster area. M has until Dec. 31, 20X5, to replace the home to defer the gain. To defer all of the gain, M must pay at least $252,000 for the new home.
If a taxpayer has an involuntary conversion of a principal residence in a federally declared disaster, the exclusion provisions of Sec. 1033 also apply to the contents of the residence when insurance proceeds are received for their destruction.66
Previous use as a rental dwelling or other business use
Recognized gain due to depreciation recapture: If the taxpayer has previously used the home as a rental dwelling, the adjusted basis of the home will be less than its cost because of the depreciation deductions allowed while the taxpayer used it as a rental dwelling. Some or all of the gain realized on the involuntary conversion of the residence may be due to depreciation recapture. Any depreciation recapture for depreciation claimed after May 6, 1997, is not eligible for the exclusion under Sec 121.67 The gain recognized due to depreciation recapture is subject to a maximum tax rate of 25%.68
Recognized gain due to nonqualified use: If the taxpayer has owned the residence but used it other than as a principal residence at any time after Dec. 31, 2008, the period of other use is a nonqualified use for purposes of the exclusion under Sec. 121.69 However, the period of nonqualified use does not include any time during the five-year period after the last day the taxpayer or the taxpayer's spouse used the home as a principal residence.70 Neither does the period of nonqualified use include any period during which the taxpayer or the taxpayer's spouse is on qualified official extended duty at a duty station that is at least 50 miles from the home or while residing in government housing under government orders in the uniformed services, foreign service, or intelligence community. This period may not exceed 10 years.71 Any period of up to two years in which the taxpayer is absent from the home temporarily due to change of employment or health or other unforeseen circumstances as specified in the regulations is not a part of the period of nonqualified use.72
The exclusion is not available for any period of nonqualified use.73 The taxpayer must allocate any realized gain to periods of nonqualified use based on the total amount of time the taxpayer owned the home and used it for nonqualified use, divided by the total time the taxpayer owned the home.74
A taxpayer calculates the amount of the realized gain allocated to periods of nonqualified use after calculating the gain not eligible for the exclusion because of depreciation recapture for depreciation claimed after May 6, 1997.75 The gain due to depreciation recapture is not a part of the realized gain in calculating the gain allocated to periods of nonqualified use.76
The gain due to depreciation recapture and the gain allocated to periods of nonqualified use are not eligible for the Sec. 121 exclusion. However, they are eligible for the Sec. 1033 deferral. Example 10 illustrates the calculation of the gain allocated to periods of nonqualified use.
Example 10: N, a single individual, bought a house on Jan. 1, 2011, for $110,000 ($90,000 for the house and $20,000 for the land). N used the house as rental property for two years and claimed $6,385 ([$90,000 × 3.458%] + [$90,000 × 3.636%]) in modified accelerated cost recovery system depreciation on it. Thus, N had an adjusted basis in the home of $83,615. N then moved into the house on Jan. 1, 2013, and used it as a primary residence until Jan. 1, 2016, when a tornado completely destroyed the home. N collected $210,000 in insurance proceeds for the destruction of the home. N realized a total gain on the involuntary conversion of the home of $126,385 ($210,000 − $83,615). The total gain consisted of a gain of $6,385 due to depreciation recapture and a gain due to the appreciation of the home of $120,000 ($126,385 − $6,385). The gain due to depreciation recapture is not eligible for the exclusion. Of the $120,000 gain, $48,000 is gain attributable to the period of nonqualified use ($120,000 × [2 ÷ 5]). It is not eligible for the exclusion. The remaining gain of $72,000 is eligible for the exclusion. N may defer the $6,385 gain due to depreciation recapture and the $48,000 gain attributable to the period of nonqualified use by buying a different home that costs more than $138,000 ($210,000 − $72,000) or constructing a new home on the land on which the previous home sat.
Partial business use: If a taxpayer uses a separate structure for business or investment purposes located on the same land as the principal residence, the gain allocated to the separate structure is not eligible for the exclusion.77 The taxpayer must allocate the amount realized on the involuntary conversion and adjusted basis between the principal residence and the nonresidential portion using the same allocation method used to calculate depreciation.78 However, if the taxpayer uses the same structure for both residential and nonresidential purposes, no allocation is necessary.79 Example 11 illustrates the allocation between the principal residence and the nonresidential portion.
Example 11: O, a single individual, owned and lived in a home as a principal residence. Behind this home on the same land was a different house that O used as rental property. A tornado completely destroyed O's home and the house used as rental property. If a taxpayer uses a portion of the principal residence for business use, the taxpayer does not have to treat the portion of the home used for business as a separate property. All of the home may qualify for the exclusion, except for any depreciation claimed after May 6, 1997.80 The rental property would not be eligible for the exclusion.81
Home received in a like-kind exchange
A principal residence is not eligible to be received in a like-kind exchange because a principal residence is not used productively in a trade or business or held for investment.82 However, a taxpayer could have received a house used for business or investment purposes in a like-kind exchange and later converted it to a principal residence. Any such home is not eligible for the exclusion for five years after the date of acquisition.83 However, the taxpayer may use the involuntary conversion provisions to defer the recognition of the gain. Example 12 illustrates the rule on a principal residence received in a like-kind exchange.
Example 12: P, a single individual, exchanged Old House used for rental purposes on Oct. 14, 2011, for New House to be used as rental property. New House was already leased to a tenant, and P took New House subject to the lease. On Feb. 1, 2014, P converted New House to a principal residence. On June 8, 2016, a fire completely destroyed New House. P received $219,500 in insurance proceeds. P's adjusted basis in the house was $122,800, which does not include P's basis in the land. P realized a gain of $96,700, of which $22,400 was due to depreciation recapture for depreciation P claimed after May 6, 1997. Because P has not held New House for more than five years from the date acquired in a like-kind exchange, P may not exclude any of the gain under Sec. 121. However, P may defer all of the gain by constructing a new principal residence that costs more than $219,500 on the land. P may also buy a new principal residence that costs more than $219,500 plus the cost of the land.
Severance damages for partial condemnations
Sometimes a governmental entity will condemn part of a taxpayer's property under the power of eminent domain. The government will pay for the part of the property condemned, as required by the Takings Clause of the Fifth Amendment to the U.S. Constitution.84 The government may also pay severance damages to the taxpayer for a decline in the value of the portion of the property the taxpayer retains.
The taxpayer must make a reasonable allocation of the basis of the property to the portion sold under the condemnation. The taxpayer calculates gain or loss on the portion of the property sold. Presumably, the taxpayer should be able to exclude this gain as a partial sale of a principal residence.85 The taxpayer reduces the adjusted basis in the remainder of the property by the severance damages paid.86 Example 13 shows how a taxpayer treats a sale due to a partial condemnation and severance damages received for the decline in value of the remaining property.
Example 13: Q, a single individual, bought a home on 15 acres 18 years ago. The state condemned 10 of the 15 acres. Q retained ownership of the remaining five acres and his principal residence, which was on the retained land. Q's adjusted basis in the home itself was $450,000. Q's adjusted basis in the 15 acres was $120,000 ($8,000 per acre), for a total basis of $570,000 ($450,000 + $120,000). Q allocated $80,000 ($8,000 × 10) of the $120,000 basis in the land to the sale of the 10 acres as a result of the condemnation. The state paid Q $100,000 for the land, which was its FMV. Q realizes a $20,000 ($100,000 − $80,000) long-term capital gain on the sale of the 10 acres. If the law considers the sold acreage as part of Q's principal residence, Q should be able to exclude this gain from gross income. The state also paid Q $50,000 in severance damages for the decline in the value of his home and the five acres Q retained. Q treats the severance damages as a reduction in the adjusted basis of the home and the remaining five acres. Q's adjusted basis in the home and the retained five acres is $440,000 ($570,000 − $80,000 − $50,000). If the severance damages had exceeded Q's remaining $490,000 ($570,000 − $80,000) adjusted basis in the property, Q would have realized a gain on that portion of the property.
A taxpayer may defer a gain by purchasing similar property within the time allowed under the deferral rules in Sec. 1033 or by restoring property the state partially condemned. A taxpayer makes a partial sale of a principal residence when the government condemns the taxpayer's principal residence. The law should also treat the severance damages received for the remainder as a partial sale.87 The regulations do not require each partial sale to reset the two-year window for purposes of the Sec. 121 exclusion. The partial sales count as one for purposes of the two-year rule.88 If the taxpayer purchases a similar property within the time allowed by Sec. 1033, the taxpayer's adjusted basis in the retained portion of the original property is zero. The taxpayer's adjusted basis in the newly acquired property is its cost minus the gain deferred.89 Example 14 shows the deferral of a gain on a principal residence caused by severance damages.
Example 14: R, a single individual, owned a principal residence that had a basis of $500,000 and an FMV of $900,000. The state built an airport partially on the land that was a part of the taxpayer's principal residence. The state paid R $90,000 for a small corner of the property needed for the airport. The allocated basis for this corner was $30,000. Therefore, R realized a $60,000 ($90,000 − $30,000) long-term capital gain. Because the land was a part of R's principal residence, R may elect to exclude this gain under Sec. 121. The state also paid R severance damages of $700,000 for the decrease in property value. R realized a $230,000 long-term capital gain ($700,000 − $470,000 remaining basis). R purchased a new home within the time allowed. Of the $230,000 of gain realized, R may exclude $190,000 under Sec. 121 ($250,000 limit − $60,000 previously used in the prior partial sale). R's adjusted amount realized is $510,000 ($700,000 − $190,000), which creates a gain realized for Sec. 1033 of $40,000 ($510,000 − $470,000). R may defer this $40,000 gain as an involuntary conversion. R's basis in his retained property is $0. If R pays $800,000 for his new property, R's basis in the replacement property is $760,000 ($800,000 − $40,000).
Dual mechanisms for nonrecognition
Sec. 121 and Sec. 1033 each provide a mechanism for nonrecognition of gain on an involuntary conversion of a principal residence. If the taxpayer meets the ownership and use tests, Sec. 121 allows for an exclusion of gain up to $250,000 ($500,000 for married filing jointly). The exclusion amount may be less if the taxpayer did not use the home exclusively as a principal residence. Sec. 1033 allows for deferral of gain if the taxpayer purchases or builds a replacement home within the time allowed. However, the taxpayer will have to reduce the basis in the new home by the amount of any deferred gain. A taxpayer may be able to use both provisions for the same involuntary conversion to exclude part of the gain and defer all or part of the remaining gain.
5Secs. 1221 and 1222(3).
7Regs. Sec. 1.121-1(c).
10Regs. Sec. 1.121-3(e)(2)(i).
11Regs. Secs. 1.121-2(a)(2) and (a)(4), Example (1).
12Regs. Sec. 1.121-1(b)(1).
13Sec. 121(e) and Regs. Sec. 1.121-4(f).
14Regs. Sec. 1.121-1(b)(2).
15Secs. 121(b)(2)(A) and (3).
17Regs. Sec. 1.121-1(c)(2)(i).
18Regs. Sec. 1.121-1(c)(4), Example (4).
19Regs. Sec. 1.121-1(c)(4), Example (5).
20Sec. 162(a), flush language.
21Regs. Sec. 1.121-1(c)(2)(i).
23Regs. Sec. 1.121-4(a).
24Regs. Sec. 1.121-1(c)(3)(i).
25Regs. Sec. 1.121-1(c)(3)(ii).
26Sec. 121(d)(7) and Regs. Sec. 1.121-1(c)(2)(ii).
27Chief Counsel Advice (CCA) 200734021.
29Rev. Rul. 80-175, discussed in CCA 200734021.
30Regs. Sec. 1.121-1(b)(3)(i).
31Regs. Sec. 1.121-1(b)(3)(ii)(A).
42Rev. Rul. 74-8.
46Regs. Sec. 1.165-9(a) and Sec. 165(c)(3).
49Regs. Sec. 1.121-4(d)(2).
50Secs. 1221 and 1223(1)(A).
53Secs. 121(d)(5)(C) and 1223.
57Regs. Sec. 1.165-9(a).
67Regs. Sec. 1.121-1(d)(2).
71Secs. 121(b)(5)(C)(ii)(II), (d)(9)(A), and (d)(9)(C).
75Secs. 121(b)(5)(D)(i) and (d)(6).
77Regs. Sec. 1.121-1(e)(1).
78Regs. Sec. 1.121-1(e)(3).
79Regs. Sec. 1.121-1(e)(1).
84"[N]or shall private property be taken for public use, without just compensation" (U.S. Const. amend. V).
85Regs. Sec. 1.121-4(e)(1)(ii).
86Rev. Rul. 68-37.
87Regs. Sec. 1.121-4(e)(1)(ii).
88Regs. Sec. 1.121-4(e)(1)(ii)(B).
89Rev. Rul. 83-49.
|Alan D. Campbell, CPA, Ph.D., CMA, is an assistant professor of accounting at Stephen F. Austin State University in Nacogdoches, Texas. Kacie Czapla, J.D., LL.M., is a member of TLC Law PLLC in Tyler, Texas. For more information on this article, contact firstname.lastname@example.org.