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Remodeling Similar Property Defers Involuntary-conversion Gain

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Feb 27th 2018
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In many parts of the country, property values have increased dramatically. So it’s not uncommon for property to be insured for much more than its original cost or, in the case of a business asset, the cost after adjustment downward for previously claimed depreciation deductions.

But what if, say, a fire destroys a building and the insurance proceeds exceed your cost? Of course, you don’t have a “gain” in the economic sense. Taxes, though, are another story; you do have a gain, just the same as if you’d reaped a profit on the sale of the building.

Ordinarily, you’re dinged for taxes on the gain in the year you receive insurance proceeds that cover the loss of property that’s stolen or damaged or destroyed due to a fire, a flood and the like. Cue Code Section 1033.It allows you to delay the day of reckoning with the IRS on some or all of the gain on insurance reimbursements for a fire or some other event that qualifies as an “involuntary conversion.”

To become eligible for this tax deferral, you must buy (or acquire a controlling interest, i.e. 80 percent, in a corporation that owns) property that’s “similar or related in service or use” to the converted property within the specified deadlines for replacement.

The IRS has ruled that the “similar or related” requirement is satisfied when the taxpayer remodels an existing nearby structure that it already owns. Under the facts of the ruling, for example, Procrustes Furniture operated its business from three buildings located on the same street. A fire destroyed one of the buildings, yet the insurance proceeds exceeded its cost.

Instead of acquiring another building, Procrustes decided to use the proceeds to renovate or remodel the two remaining structures. Letter Ruling 8329015 concluded that the remodeling of the remaining buildings qualifies as replacement property for purposes of Code Section 1033.

Tax is Merely Postponed, not Erased

The law requires Procrustes to subtract the deferred gain on the conversion property from the cost of the replacement for purposes of determining its basis for depreciation, as well as on a subsequent sale when the deferral comes to an end and the IRS collects its share of the proceeds.

If Procrustes foregoes the postponement and declare the gain, its basis for the replacement property is its cost. Therefore, it might prefer to pay a capital gains tax to obtain a higher basis for depreciation of the replacement property.

In a previous column, I noted that the postponement-replacement rules also apply when you’ve a gain from property condemned by a governmental authority or sold because of a threatened, imminent or actual condemnation.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 225 and counting). 

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