A gain from the condemnation of your main home may be eligible for exclusion from taxable income, just as a gain from a sale. Gains from the condemnation of business or investment property may be postponed for income tax purposes by purchasing replacement property.
An involuntary conversion, for U.S. income tax purposes, is defined as an event in which your property is destroyed, stolen, condemned, or disposed of under threat of condemnation. Involuntary conversions can result in gains or losses, as is the case with sales or exchanges. The gain or loss in the case of an involuntary conversion is the difference between the money or property received in payment, such as an insurance reimbursement or condemnation award, and the owner’s adjusted basis in the property.
Tax Treatment of Gains or Losses
These gains and losses on involuntary conversions would generally be recognized for income tax purposes, unless the property affected is your main home. The gain or loss would normally be reported on Schedule D of Form 1040, if there is a gain on personal property, or a gain or loss on property held for investment, and on Form 4797 if the property involved is property held in a business. For involuntary conversions resulting from casualties (such as storms or fire) or theft, Form 4684 may need to be filed.
Normally you cannot deduct a loss on the involuntary conversion of personal property, although losses from casualties and thefts may be deductible as an itemized deduction on Schedule A of Form 1040. Depending on the type of property you receive, you may have to report a gain. If the property you receive as a result of the involuntary conversion is similar or related in service and use, you do not have to recognize any gain, and cannot deduct any loss, and the basis of the property you receive will be the same as the basis of the converted property. You are thereby postponing the recognition of any gain on the conversion until you sell or dispose of the replacement property.
If you receive money or other property that is not similar to the converted property, you can avoid the recognition of any gain on the conversion by buying replacement property within a certain period of time.
Condemnations are involuntary conversions in which property is taken by the federal, state, or local government, or a private organization that has the legal right to take it, without the owner’s consent. The owner receives a condemnation award in the form of money or property, and the conversion is treated as a forced sale for income tax purposes.
Threat of Condemnation
A threat of condemnation exists when you have reason to believe that if you do not sell your property voluntarily, it will be condemned, based on what you have been told by a government representative or public official authorized to acquire property for public use. Your property may also be considered to be under the threat of condemnation if you learn of the decision to acquire your property through the news media and this is confirmed by a government representative or public official.
If you sell your property to someone else, when it is under the threat of condemnation, that sale may be treated as an involuntary conversion for income tax purposes. And if the buyer of your property is aware of the threat of condemnation and sells the property to the government representative or public authority, that sale will also be treated as an involuntary conversion.
If you also voluntarily sell property that is not condemned or under the threat of condemnation, but has a substantial economic relationship to property that is condemned, the sale of that related property may also be treated as an involuntary conversion. The properties may be part of the same economic unit, such as your business property, for example. In this case, you can postpone any gain realized on the sale of the economically related property by buying replacement property.
Gain or Loss from Condemnation
Your gain or loss from a condemnation is the difference between your condemnation award (the money or value of the property you receive) and your adjusted basis in the property. If your net condemnation award is greater, you have a gain. You can postpone recognition of the gain for tax purposes by buying replacement property. If only part of your property is condemned, you can postpone any gain by treating the cost of restoring that part of your property to its former usefulness as the cost of replacement property.
If your adjusted basis is greater than your condemnation award, you have a loss. A loss on property held for personal use is not deductible. But a loss on property held for investment, business, or income-producing activities is deductible in the year of the loss.
There is a “Worksheet for Condemnations” in Internal Revenue Service (IRS) Publication 544, Sales and Other Dispositions of Assets, that will help you calculate the gain from severance damages (see below), the gain or loss from the condemnation award, the amount of gain that must be recognized, and the gain that can be postponed.
Condemnation of Your Main Home
A condemnation of your main home would have the same tax treatment of a sale: you can exclude up to $250,000 ($500,000 if married filing jointly) of any gain realized, if you qualify. If your gain is more than the exclusion amount, you can postpone recognition of the gain for tax purposes by buying replacement property (another home in this case).
The condemnation award is the money you are paid, or the value of the property you receive from the government or other condemning authority for your property, or the amount you receive on a sale of disposal of your property when it is under the threat of condemnation.
Payment of Debts
If you have debts outstanding on the property that is being condemned, such as a mortgage loan or real estate taxes, the amount of liabilities that are paid for you are considered part of the condemnation award.
Payments to Relocate
If you receive payments to relocate because you have been displaced from your home, place of business, or farm as part of a federally assisted program, these payments are not considered part of the condemnation award, and do not have to be included in your taxable income. If you receive federal assistance to buy replacement housing, the payments you made to buy replacement housing are included in your cost basis of the property.
Severance damages are paid if part of your property is condemned and as a result of the condemnation the value of the part of the property you keep is reduced. For example, if your property is condemned in order to build a highway that passes by or through your land, and as a result of the highway construction you have to make repairs to the part of your property you keep, the amounts you receive to cover those costs would be considered severance damages. These payments are not considered to be part of the condemnation award for purposes of determining gain or loss on the condemnation, provided the severance damages are specified in writing in the condemnation agreement.
Severance damages are treated as a reduction of your basis in the remaining property after a condemnation. If the severance damages are for a specific part of the remaining property, you should reduce your basis in that part of the property. And, if the severance damages you receive are more than your adjusted basis in the property, you have a gain. If you buy replacement property, you can choose to postpone the gain.
The severance damages you receive should be reduced by the expenses you incur in order to obtain the damages. These expenses could include legal costs, appraisal fees, or engineering expenses. Also, your severance damages may have to be reduced by any special assessment charged on your remaining property after a condemnation. For example:
Part of your property is condemned in order to widen a street. You are granted a condemnation award of $8,000 for a strip of your land, and severance damages of $1,000 for the remaining part of the property that you keep.
You spend $300 in order to obtain the severance damages.
The city charges you a special assessment of $900 on your remaining property for the street improvement.
The city pays you $8,100: the condemnation award of $8,000 plus the severance damages of $1,000, less the special assessment of $900.
Your severance damages of $1,000 are reduced by your expenses of $300 to arrive at your net severance damages of $700. This is then reduced to zero by subtracting $700 of the special assessment of $900.
This leaves a balance of $200 ($900 minus $700) from the special assessment that reduces the condemnation award to a net amount of $7,800 ($8,000 minus $200). This $7,800 is the amount that would be used to determine if you have a net gain or loss on the condemnation.
Part Home - Part Business
If part of the property that is condemned was used as your home and part was used for business, or was rented, you will need to calculate the gain or loss from condemnation as if they were two separate properties. The gain or loss on each part may have different tax treatments. You would need to go through the following steps:
Allocate the condemnation award between the personal and business parts of the property, in proportion to the original basis allocated to each part.
Determine the adjusted basis in the personal and business portions of the property.
Additions or improvements that benefit the entire property should be allocated between the personal and business portions based on their proportionate original basis.
Additions or improvements that benefit one or the other parts should be added to the basis of that part of the property.
Casualty losses or other basis reductions that affected the entire property should be taken as proportionate reductions in the basis of both the personal and business parts of the property.
Casualty losses or other basis reductions that affected only the personal or business parts of the property should be taken as a reduction in the basis of the corresponding part of the property.
Depreciation taken on the business part of the property should be taken as a reduction in the basis of the business part.
Determine the gain or loss on the personal part and business part of the property (the proportionate part of the condemnation award minus the adjusted basis of each part)
You may be able to exclude any gain on the condemnation of the part of the property used as your home. A loss on the part used as your home would not be deductible.
A gain or loss on the business part may be recognized as an ordinary or capital gain or loss, or if there is a gain, it may be postponed by buying replacement property.
You may have a gain or a loss on condemnation, or you may not have any gain or loss, depending on what type of condemnation award you receive.
When You Receive Similar Property
If you receive property in a condemnation, that is similar or related in service and use to your original property that was condemned, you do not have any gain or loss. Your basis in the new property is the same as your basis in the old property.
When You Receive Money or Unlike Property
You would ordinarily have to report the gain or loss on condemnation, unless the property was your main home and you qualify for an exclusion. But you can postpone recognition of the gain by buying replacement property. Buying replacement property includes buying at least an 80% interest in a corporation that owns property that is similar or related in service or use.
In order to postpone all of the gain, the amount you spend on replacement property must be at least as much as you realized on the condemnation. If you spend less than that amount on replacement property, you will have to recognize the excess, unspent amount as a taxable gain. Your basis in the replacement property will be its cost, reduced by any unrecognized gain (the gain you are able to postpone) on the condemnation.
Postponing Gain on Severance Damages
If part of your property is condemned, and you receive severance damages for the remaining part, in addition to a condemnation award for the condemned part, you can postpone gain on both the severance damages and the condemnation by buying replacement property. If the replacement property costs at least as much as the total of your net severance damages plus your net condemnation award, you can postpone the entire gain.
Replacement property, for purposes of postponing the gain, includes nearby property that will allow you to continue your business, if the condemned property was business property. If nearby property is not available, you can sell your remaining property after the condemnation and then postpone any gain realized on the sale by buying replacement property.
To postpone a gain on condemnation, you must buy replacement property for the specific purpose of replacing the condemned property. In order to qualify, the replacement property must be similar or related in service and use to the property that was condemned. This is determined based on whether you were an owner-user of the condemned property, or an owner-investor.
For example, if you used the condemned property as your home, the replacement property must also be used as your home, and not as a business. If the replacement property is business or investment property, it must serve the same purpose as the condemned property. If the condemned property was rental property, the replacement property you purchase must be similar in terms of the management activities you carry out with respect to the property, the kind of services you provide to tenants, and the nature of the associated business risks to you.
In order to postpone recognition of a gain from condemnation, you must buy the replacement property within a certain period of time called the replacement period. The replacement period starts on the earlier of the date on which you dispose of the condemned property, or the date on which the threat of condemnation begins. The replacement period ends 2 years after the end of the tax year in which you realize any part of the gain on the condemnation. If the condemned property was real property used for business or investment purposes, the replacement period extends to 3 years. And, if the condemned property was in the New York Liberty Zone, the replacement period is 5 years.
The year in which you realize any gain on the condemnation is when the payments you receive exceed your adjusted basis in the property, if you are on the cash basis. The replacement period starts to run even if these are advance payments and the final amount of the condemnation award has not yet been determined. Once the payments received are more than your basis in the property, the replacement period begins.
If you are an accrual basis taxpayer, the period in which you realize a gain on the condemnation is when all the events that determine the amount of the condemnation award have occurred and the amount of the award can be determined with reasonable accuracy, or when you actually or constructively receive the award, whichever year comes first.
If you purchased your replacement property after there was a threat of condemnation but before the property was actually condemned, and you still have the replacement property at the time of the actual condemnation, you have met the replacement period test. But property purchased before there was a threat of condemnation is not considered to have been purchased during the replacement period.
How to Report Your Election to Postpone the Gain
When you have a gain on a condemnation and elect to postpone the gain by purchasing replacement property, you need to file a statement with your tax return for the year in which you realize the gain, stating your election to postpone the gain and including all necessary details. If you purchase the replacement property after you have filed your tax return for the year in which you realized the gain, you should also attach a statement to your return for that year, with details on the replacement property.
Reporting a Gain or Loss on Condemnation
If you have a gain on condemnation and you do not elect to postpone it, the way you report the gain on your tax return will depend on whether the condemned property was personal-use property or business property.
If the condemned property was your main home, you can exclude gain of up to $250,000 ($500,000 if married filing jointly) if you qualify. Gains on other personal-use property are reported as capital gains on Schedule D. Losses on condemnations of personal-use property are not deductible. But, if you receive a Form 1099-S, Proceeds from Real Estate Transactions, you have to report the transaction on Schedule D even though the loss is not deductible.
Gains or losses from condemnations of property held for business or profit are reported on Form 4797. Gains may have to be reported as ordinary income.