Involuntary Conversions An involuntary conversion occurs when your property is destroyed,stolen, condemned, or disposed of under the threat of condemnation andyou receive other property or money in payment, such as insurance or acondemnation award. Involuntary conversions are also calledinvoluntary exchanges. Gain or loss from an involuntary conversion of your property isusually recognized for tax purposes, unless the property is your mainhome. You report the gain or deduct the loss on your tax return forthe year you realize it. (You cannot deduct a loss from an involuntaryconversion of property you held for personal use unless the lossresulted from a casualty or theft.) However, depending on the type of property you receive, you may nothave to report a gain on an involuntary conversion. You do not reportthe gain if you receive property that is similar or related in serviceor use to the converted property. Your basis for the new property isthe same as your basis for the converted property. The gain on theinvoluntary conversion is deferred until a taxable sale or exchangeoccurs. If you receive money or property that is not similar or related inservice or use to the involuntarily converted property and you buyqualifying replacement property within a certain period of time, youcan choose to postpone reporting the gain. This publication explains the treatment of a gain or loss from acondemnation or disposition under the threat of condemnation. If youhave a gain or loss from the destruction or theft of property, seePublication 547. Condemnations Condemnation is the process by which private property is legallytaken for public use without the owner's consent. The property may betaken by the federal government, a state government, a politicalsubdivision, or a private organization that has the power to legallytake it. The owner receives a condemnation award (money or property)in exchange for the property taken. A condemnation is like a forcedsale, the owner being the seller and the condemning authority beingthe buyer. Example.A local government authorized to acquire land for public parks toldyou that it wished to acquire your property. After the localgovernment took action to condemn your property, you went to court tokeep it. But the court decided in favor of the local government, whichtook your property and paid you an amount fixed by the court. This isa condemnation of private property for public use. Threat of condemnation.A threat of condemnation exists if a representative of a governmentbody or a public official authorized to acquire property for publicuse tells you that the government body or official has decided toacquire your property. You must have reasonable grounds to believethat, if you do not sell voluntarily, your property will be condemned. The sale of your property to someone other than the condemningauthority qualifies as an involuntary conversion, provided you havereasonable grounds to believe that your property will be condemned. Ifthe buyer of this property knows at the time of purchase that it willbe condemned and sells it to the condemning authority, this sale alsoqualifies as an involuntary conversion. Reports of condemnation.A threat of condemnation exists if you learn of a decision toacquire your property for public use through a report in a newspaperor other news medium, and this report is confirmed by a representativeof the government body or public official involved. You must havereasonable grounds to believe that they will take necessary steps tocondemn your property if you do not sell voluntarily. If you relied onoral statements made by a government representative or publicofficial, the Internal Revenue Service may ask you to get writtenconfirmation of the statements. Example.Your property lies along public utility lines. The utility companyhas the authority to condemn your property. They company notifies youit intends to acquire your property by negotiation or condemnation. Athreat of condemnation exists when you receive the notice. Related property voluntarily sold.A voluntary sale of your property may be treated as a forced salethat qualifies as an involuntary conversion if the property had asubstantial economic relationship to property of yours thatwas condemned. A substantial economic relationship exists if togetherthe properties were one economic unit. You must also show that thecondemned property could not reasonably or adequately be replaced. Youcan choose to postpone reporting the gain by buying replacementproperty. See Postponement of Gain, later. Gain or LossFrom Condemnations If your property was condemned or disposed of under the threat ofcondemnation, figure your gain or loss by comparing the adjusted basisof your condemned property with your net condemnation award. If your net condemnation award is more than the adjusted basis ofthe condemned property, you have a gain. You can postpone reportinggain from a condemnation if you buy replacement property. If only partof your property is condemned, you can treat the cost of restoring theremaining part to its former usefulness as the cost of replacementproperty. See Postponement of Gain, later. If your net condemnation award is less than your adjusted basis,you have a loss. If your loss is from property you held for personaluse, you cannot deduct it. You must report any deductible loss in thetax year it happened. TaxTip: You can use Part 2 of Table 1-3 to figure yourgain or loss from a condemnation award. Main home condemned.If you have a gain because your main home is condemned, yougenerally can exclude the gain from your income as if you had sold orexchanged your home. You may be able to exclude up to $250,000 of thegain (up to $500,000 if married filing jointly). For information onthis exclusion, see Publication 523, Selling Your Home. Ifyour gain is more than the amount you can exclude but you buyreplacement property, you may be able to postpone reporting the restof the gain. See Postponement of Gain, later. Table 1-3 Condemnation award.A condemnation award is the money you are paid or the value ofother property you receive for your condemned property. The award isalso the amount you are paid for the sale of your property underthreat of condemnation. Payment of your debts.Amounts taken out of the award to pay your debts are consideredpaid to you. Amounts the government pays directly to the holder of amortgage or lien against your property are part of your award, evenif the debt attaches to the property and is not your personalliability. Example.The state condemned your property for public use. The award was setat $200,000. The state paid you only $148,000 because it paid $50,000to your mortgage holder and $2,000 accrued real estate taxes. You areconsidered to have received the entire $200,000 as a condemnationaward. Interest on award.If the condemning authority pays you interest for its delay inpaying your award, it is not part of the condemnation award. You mustreport the interest separately as ordinary income. Payments to relocate.Payments you receive to relocate and replace housing because youhave been displaced from your home, business, or farm as a result offederal or federally assisted programs are not part of thecondemnation award. Do not include them in your income. Replacementhousing payments used to buy new property are included in theproperty's basis as part of your cost. Net condemnation award.A net condemnation award is the total award you received, or areconsidered to have received, for the condemned property minus yourexpenses of obtaining the award. If only a part of your property wascondemned, you must also reduce the award by any special assessmentlevied against the part of the property you retain. This is discussedlater under Special assessment taken out of award. Severance damages.Severance damages are not part of the award paid for the propertycondemned. They are paid to you if part of your property is condemnedand the value of the part you keep is decreased because of thecondemnation. For example, you may receive severance damages if your property issubject to flooding because you sell flowage easement rights (thecondemned property) under threat of condemnation. Severance damagesmay also be given to you if, because part of your property iscondemned for a highway, you must replace fences, dig new wells orditches, or plant trees to restore your remaining property to the sameusefulness it had before the condemnation. The contracting parties should agree on the amount of the severancedamages and put that in writing. If this is not done, all proceedsfrom the condemning authority are considered awarded for yourcondemned property. You may not make a completely new allocation of the total awardafter the transaction is completed. However, you may show how much ofthe award both parties intended for severance damages. The severancedamages part of the award is determined from all the facts andcircumstances. Example.You sold part of your property to the state under threat ofcondemnation. The contract you and the condemning authority signedshowed only the total purchase price. It did not specify a fixed sumfor severance damages. However, at settlement, the condemningauthority gave you closing papers showing clearly the part of thepurchase price that was for severance damages. You may treat this partas severance damages. Treatment of severance damages.Your net severance damages are treated as the amount realized froman involuntary conversion of the remaining part of your property. Usethem to reduce the basis of the remaining property. If the amount ofseverance damages is based on damage to a specific part of theproperty you kept, reduce the basis of only that part by the netseverance damages. If your net severance damages are more than the basis of yourretained property, you have a gain. You may be able to postponereporting the gain. See the later discussion, Postponement ofGain. TaxTip: You can use Part I of Table 1-3 to figure any gainfrom severance damages and to refigure the adjusted basis of theremaining part of your property. Net severance damages.To figure your net severance damages, you must first reduce yourseverance damages by your expenses in obtaining the damages. You thenreduce them by any special assessment (described later) levied againstthe remaining part of the property and taken out of the award by thecondemning authority. The balance is your net severance damages. Expenses of obtaining a condemnation award and severancedamages.Subtract the expenses of obtaining a condemnation award, such aslegal, engineering, and appraisal fees, from the amount of the totalaward. Also subtract the expenses of obtaining severance damages,which may include similar expenses, from the severance damages paid toyou. If you cannot determine which part of your expenses is for eachpart of the condemnation proceeds, you must make a proportionateallocation. Example.You receive a condemnation award and severance damages. One-fourthof the total was designated as severance damages in your agreementwith the condemning authority. You had legal expenses for the entirecondemnation proceeding. You cannot determine how much of your legalexpenses is for each part of the condemnation proceeds. You mustallocate one-fourth of your legal expenses to the severance damagesand the other three-fourths to the condemnation award. Special assessment taken out of award.When only part of your property is condemned, a special assessmentlevied against the remaining property may be taken out of yourcondemnation award. An assessment may be levied if the remaining partof your property benefited by the improvement resulting from thecondemnation. Examples of improvements that may cause a specialassessment are widening a street and installing a sewer. To figure your net condemnation award, you generally reduce theaward by the amount of the assessment taken out of the award. Example.To widen the street in front of your home, the city condemned a25-foot deep strip of your land. You were awarded $5,000 forthis and spent $300 to get the award. Before paying the award, thecity levied a special assessment of $700 for the street improvementagainst your remaining property. The city then paid you only $4,300.Your net award is $4,000 ($5,000 total award minus $300 expenses inobtaining the award and minus $700 for the special assessment takenout). If the $700 special assessment were not taken out of the award, andyou were paid $5,000, your net award would be $4,700 ($5,000 minus$300). The net award would not change, even if you later paid theassessment from the amount you received. Severance damages received.If severance damages are included in the condemnation proceeds, thespecial assessment taken out is first used to reduce the severancedamages. Any balance of the special assessment is used to reduce thecondemnation award. Example.You were awarded $4,000 for the condemnation of your property and$1,000 for severance damages. You spent $300 to obtain the severancedamages. A special assessment of $800 was taken out of the award. The$1,000 severance damages are reduced to zero by first subtracting the$300 expenses and then $700 of the special assessment. Your $4,000condemnation award is reduced by the $100 balance of the specialassessment, leaving a $3,900 net condemnation award. Part business or rental.If you used part of your condemned property as your home and partas business or rental property, treat each part as a separateproperty. Figure your gain or loss separately, because gain or loss oneach part may be treated differently. Some examples of this type of property are a building in which youlive and operate a grocery, and a building in which you live on thefirst floor and rent out the second floor. Example.You sold your building for $24,000 under threat of condemnation toa public utility company that had the authority to condemn. You rentedhalf the building and lived in the other half. You paid $25,000 forthe building and spent an additional $1,000 for a new roof. Youclaimed allowable depreciation of $4,600 on the rental half. You spent$200 in legal expenses to obtain the condemnation award. Figure yourgain or loss as follows. Residential Part Business Part Condemnation award received $12,000 $12,000 Minus: Legal expenses, $200        100        100 Net condemnation award 11,900 11,900 Minus: Adjusted basis  1/2 of original cost, $25,000 12,500 12,500  1/2 of cost of roof, $1,000        500        500   Total     13,000 13,000 Minus: Depreciation      4,600 Adjusted basis, business part      8,400 Loss on residential property $ 1,100 Gain on business property $ 3,500 The loss on the residential part of the property is notdeductible. Postponement of Gain Do not report the gain on condemned property if you receive onlyproperty that is similar or related in service or use to it. Yourbasis for the new property is the same as your basis for the old. You must ordinarily report the gain if you receive money or unlikeproperty. You can choose to postpone reporting the gain if you buyproperty that is similar or related in service or use to the condemnedproperty within the replacement period, discussed later. You can alsochoose to postpone reporting the gain if you buy controlling interest(at least 80%) in a corporation owning property that is similar orrelated in service or use to the condemned property. SeeControlling interest in a corporation, later. To postpone reporting all the gain, you must buy replacementproperty costing at least as much as the amount realized for thecondemned property. If the cost of the replacement property is lessthan the amount realized, you must report the gain up to the amount ofthe unspent part of the amount realized. TaxTip: You can use Part 3 of Table 1-3 to figure the gainyou must report and your postponed gain. Reduce the basis of the replacement property by the amount ofpostponed gain. Also, if your replacement property for propertycondemned after August 20, 1996, is stock in a corporation that ownsproperty that is similar or related in service or use, the corporationwill generally reduce its basis in its assets by the amount by whichyou reduce your basis in the stock. See Controlling interest in acorporation, later. Postponing gain on severance damages.If you received severance damages for part of your property becauseanother part was condemned and you buy replacement property, you canchoose to postpone reporting gain. See Treatment of severancedamages, earlier. You can postpone reporting all your gain ifthe replacement property costs at least as much as your net severancedamages plus your net condemnation award (if resulting in gain). You can also make this choice if you spend the severance damages,together with other money you received for the condemned property (ifresulting in gain), to acquire nearby property that will allow you tocontinue your business. If suitable nearby property is not availableand you are forced to sell the remaining property and relocate inorder to continue your business, see Postponing gain on the saleof related property, next. If you restore the remaining property to its former usefulness, youcan treat the cost of restoring it as the cost of replacementproperty. Postponing gain on the sale of related property.If part of your property is condemned and you sell the related partand buy replacement property, you can choose to postpone reportinggain on the sale. You must meet the requirements explained earlierunder Related property voluntarily sold. You can postponereporting all your gain if the replacement property costs at least asmuch as the amount realized from the sale plus your net condemnationaward (if resulting in gain) plus your net severance damages, if any(if resulting in gain). Buying replacement property from a related person.Certain taxpayers cannot postpone reporting gain from acondemnation if they buy the replacement property from a relatedperson. For information on related persons, see NondeductibleLoss under Sales and Exchanges Between Related Personsin chapter 2. This rule applies to the following taxpayers. C corporations. Partnerships in which more than 50% of the capital orprofits interest is owned by C corporations. For condemnations after June 8, 1997, all others (includingindividuals, partnerships (other than those in (2) above), and Scorporations) if the total realized gain for the tax year on allinvoluntarily converted properties on which there are realized gainsis more than $100,000. For taxpayers described in (3) above, gains cannot be offset withany losses when determining whether the total gain is more than$100,000. If the property is owned by a partnership, the $100,000limit applies to the partnership and each partner. If the property isowned by an S corporation, the $100,000 limit applies to the Scorporation and each shareholder. Exception.This rule does not apply if the related person acquired theproperty from an unrelated person within the replacement period. Advance payment.If you pay a contractor in advance to build your replacementproperty, you have not bought replacement property unless it isfinished before the end of the replacement period. Replacement property.To postpone reporting gain, you must buy replacement property forthe specific purpose of replacing your condemned property. You do nothave to use the actual funds from the condemnation award to acquirethe replacement property. Property you acquire by gift or inheritancedoes not qualify as replacement property. Similar or related in service or use.Your replacement property must be similar or related in service oruse to the property it replaces. If the condemned property is real property you held for use in yourtrade or business or for investment (other than property held mainlyfor sale) but your replacement property is not similar or related inservice or use, it will be treated as such if it is like-kind propertyto be held for use in a trade or business or for investment. For adiscussion of like-kind property, see Like Property underLike-Kind Exchanges, later. Owner-user.If you are an owner-user, similar or related in service or usemeans that replacement property must function in the same way as theproperty it replaces. Example.Your home was condemned, and you invested the proceeds from thecondemnation in a grocery store. Your replacement property is notsimilar or related in service or use to the condemned property. To besimilar or related in service or use, your replacement property mustalso be used by you as your home. Owner-investor.If you are an owner-investor, similar or related in service or usemeans that any replacement property must have the same relationship ofservices or uses to you as the property it replaces. You decide thisby determining all the following information. Whether the properties are of similar service to you. The nature of the business risks connected with theproperties. What the properties demand of you in the way of management,service, and relations to your tenants. Example.You owned land and a building you rented to a manufacturingcompany. The building was condemned. During the replacement period,you had a new building built on other land you already owned. Yourented out the new building for use as a wholesale grocery warehouse.Because the replacement property is also rental property, the twoproperties are considered similar or related in service or use ifthere is a similarity in all the following areas. Your management activities. The amount and kind of services you provide to yourtenants. The nature of your business risks connected with theproperties. Leasehold replaced with fee simple property.Fee simple property you will use in your trade or business or forinvestment can qualify as replacement property that is similar orrelated in service or use to a condemned leasehold if you use it inthe same business and for the identical purpose as the condemnedleasehold. If the condemned leasehold has 30 or more years to run, thefee simple property is like-kind property. A "fee simple" property interest generally is one in which theowner is entitled to the entire property, with unconditional power todispose of it during his or her lifetime. A leasehold is property heldunder a lease, usually for a term of years. Outdoor advertising display replaced with real property.You can choose to treat an outdoor advertising display as realproperty. If you make this choice and you replace the display withreal property in which you hold a different kind of interest, yourreplacement property can qualify as like-kind property. For example,real property bought to replace a destroyed billboard and leasedproperty on which the billboard was located qualifies as property of alike kind. You can make this choice only if you did not claim a section 179deduction for the display. You cannot cancel this choice unless youget the consent of the Internal Revenue Service. An outdoor advertising display is a sign or device rigidlyassembled and permanently attached to the ground, a building, or anyother permanent structure used for commercial or other advertisementto the public. Substituting replacement property.Once you designate certain property as replacement property on yourtax return, you may not substitute other qualified property. But ifyour previously designated replacement property does not qualify, youcan substitute qualified property if you acquire it within thereplacement period. Controlling interest in a corporation.You can replace property by acquiring a controlling interest in acorporation that owns property similar or related in service or use toyour condemned property. You have controlling interest if you ownstock having at least 80% of the combined voting power of allclasses of voting stock and at least 80% of the total number ofshares of all other classes of stock. Basis adjustment to corporation's property.For condemnations occurring after August 20, 1996, the basis ofproperty held by the corporation at the time you acquired control mustbe reduced by the amount of your postponed gain, if any. You are notrequired to reduce the adjusted bases of the corporation's propertiesbelow your adjusted basis in the corporation's stock (determined afterreduction by the amount of your postponed gain). Allocate this reduction to the following classes of property in theorder shown below. Property that is similar or related in service or use to thecondemned property. Depreciable property not reduced in (1) above. All other property. If two or more properties fall in the same class, allocate thereduction to each property in proportion to the adjusted bases of allthe properties in that class. The reduced basis of any single propertycannot be less than zero. Main home replaced.If your gain from a condemnation of your main home is more than theamount you can exclude from your income (see Main home condemnedunder Gain or Loss From Condemnations, earlier), youcan postpone reporting the rest of the gain by buying replacementproperty that is similar or related in service or use. To postponereporting all the gain, the replacement property must cost at least asmuch as the amount realized from the condemnation minus the excludedgain. You must reduce the basis of your replacement property by theamount of postponed gain. Also, if you postpone reporting any part ofyour gain under these rules, you are treated as having owned and usedthe replacement property as your main home for the period you ownedand used the condemned property as your main home. Replacement period.To postpone reporting your gain from a condemnation, you must buyreplacement property within a certain period of time. This is the"replacement period." The replacement period for a condemnation begins on the earlier ofthe following dates. The date on which you disposed of the condemnedproperty. The date on which the threat of condemnation began. The replacement period luxury hotels in Zakopaneends 2 years after the end of thefirst tax year in which any part of the gain on the condemnation isrealized. If real property held for use in a trade or business orfor investment (not including property held primarily for sale) iscondemned, the replacement period ends 3 years after theend of the first tax year in which any part of the gain on thecondemnation is realized. However, this 3-year replacement periodcannot be used if you replace the condemned property by acquiringcontrol of a corporation owning property that is similar or related inservice or use. Determining when gain is realized.If you are a cash basis taxpayer, you realize gain when you receivepayments that are more than your basis in the property. If thecondemning authority makes deposits with the court, you realize gainwhen you withdraw (or have the right to withdraw) amounts that aremore than your basis. This applies even if the amounts received are only partial oradvance payments and the full amount of the award has not yet beendetermined. A replacement will be too late if you wait for a finaldetermination that does not take place in the applicable replacementperiod after you first realize gain. For accrual basis taxpayers, gain (if any) accrues in the earliestyear when: All events have occurred that fix the right to thecondemnation award and the amount can be determined with reasonableaccuracy, or All or part of the award is actually or constructivelyreceived. For example, if you have an absolute right to a part of acondemnation award when it is deposited with the court, the amountdeposited accrues in the year the deposit is made even though the fullamount of the award is still contested. Replacement property bought before the condemnation.Hotels SuisseIf you buy your replacement property after there is a threat ofcondemnation but before the actual condemnation and you still hold thereplacement property at the time of the condemnation, you have boughtyour replacement property within the replacement period. Property youacquire before there is a threat of condemnation does not qualify asreplacement property acquired within the replacement period. Example.On April 3, 1998, city authorities notified you that your propertywould be condemned. On June 5, 1998, you acquired property to replacethe property to be condemned. You still had the new property when thecity took possession of your old property on September 3, 1999. Youhave made a replacement within the replacement period. Extension.You may get an extension of the replacement period if you apply tothe District Director of the Internal Revenue Service for your area.You should apply before the end of the replacement period. Yourapplication should contain all details of your need for an extension.You may file an application within a reasonable time after thereplacement period ends if you can show reasonable cause for thedelay. An extension of the replacement period will be granted if youcan show reasonable cause for not making the replacement within theregular period. Ordinarily, requests for extensions are granted near the end of thereplacement period or the extended replacement period. Extensions areusually limited to a period of 1 year or less. The high market valueor scarcity of replacement property is not a sufficient reason forgranting an extension. If your replacement property is being built andyou clearly show that the replacement or restoration cannot be madewithin the replacement period, you will be granted an extension of theperiod. Choosing to postpone gain.Report your choice to postpone reporting your gain, along with allnecessary details, on a statement attached to your return for the taxyear in which you realize the gain. If a partnership or a corporation owns the condemned property,only the partnership or corporation can choose to postponereporting the gain. Replacement property acquired after return filed.If you buy the replacement property after you file your returnreporting your choice to postpone reporting the gain, attach astatement to your return for the year in which you buy the property.The statement should contain detailed information on the replacementproperty. Amended return.If you choose to postpone reporting gain, you must file an amendedreturn for the year of the gain (individuals file Form 1040X) ineither of the following situations. You do not buy replacement property within the replacementperiod. On your amended return, you must report the gain and pay anyadditional tax due. The replacement property you buy costs less than the amountrealized for the condemned property (minus the gain you excluded fromincome if the property was your main home). On your amended return,you must report the part of the gain you cannot postpone reporting andpay any additional tax due. Time for assessing a deficiency.Any deficiency for any tax year in which part of the gain isrealized may be assessed at any time before the expiration of 3 yearsfrom the date you notify the IRS District Director for your area thatyou have replaced, or intend not to replace, the condemned propertywithin the replacement period. Changing your mind.You can change your mind about reporting or postponing the gain atany time before the end of the replacement period. Example.Your property was condemned and you had a gain of $5,000. Youreported the gain on your return for the year in which you realizedit, and paid the tax due. You buy replacement property within thereplacement period. You used all but $1,000 of the amount realizedfrom the condemnation to buy the replacement property. You now changeyour mind and want to postpone reporting the $4,000 of gain equal tothe amount you spent for the replacement property. You should file aclaim for refund on Form 1040X. Explain on Form 1040X that youpreviously reported the entire gain from the condemnation, but you nowwant to report only the part of the gain ($1,000) equal to the amountof condemnation proceeds not spent for replacement property. Reporting a CondemnationGain or Loss Generally, you report gain or loss from a condemnation on yourreturn for the year that you realize the gain or loss. Personal-use property.Report gain from a condemnation of property you held for personaluse (other than excluded gain from a condemnation of your main home orpostponed gain) on Schedule D (Form 1040). Do not report loss from a condemnation of personal-use property.But if you received a Form 1099-S (for example, showing theproceeds of a sale of real estate under threat of condemnation), youmust show the transaction on Schedule D even though the loss is notdeductible. Complete columns (a) through (e), and enter -0- in column(f). Business property.Report gain (other than postponed gain) or loss from a condemnationof property you held for business or profit on Form 4797.If you had a gain, you may have to report all or part of it asordinary income. See Like-Kind Exchanges and InvoluntaryConversions in chapter 3.