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When Does Damaged Property Qualify for a Tax Deferral Break?

Dec 27th 2018
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Tax court rules on damaged property
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Tax court rules on damaged property

The tax code provides some valuable relief when property is “involuntarily converted”—condemned by a governmental authority, stolen or damaged, or destroyed by a fire, flood or the like. Code Section 1033 allows you to defer the tax on the gain if you receive a condemnation award or insurance proceeds that exceed your basis (cost, in most cases) for the property.

To qualify under Section 1033, you must buy (or acquire a controlling interest (80 percent) in a corporation that owns) property that is “similar or related in service or use” to the converted one within the specified deadlines for replacement.

Suppose, though, that part of your property is condemned or destroyed. You collect insurance but decide to sell what’s left. The insurance proceeds clearly qualify for reinvestment deferral, but what about the proceeds of the sale?

According to Rev. Rul. 78-377, the tax-deferral break is available only if two conditions are satisfied: (1) the condemned or damaged property couldn’t be replaced repaired, etc., and (2) there was such a “substantial economic relationship” between the converted property and the property sold that they “formed one economic unit.”

Under the facts of the ruling, a shopping center was partially destroyed by fire. Tenants of the undamaged portion remained in occupancy. The owner decided not to reconstruct the damaged portion but instead sold the entire center as it was. He reinvested the insurance and sale proceeds in a qualifying replacement property.

The ruling, while conceding that the insurance proceeds were entitled to nonrecognition, concluded that the sale proceeds weren’t. Neither one of the two conditions was met: The damaged property was reparable and severable.

In the common fire-damage situation, the sale proceeds will almost never qualify for nonrecognition treatment because of the failure to satisfy condition (1)—inability to rebuild, repair, etc.

There are, however, some condemnation situations that may meet these tests. The ruling gives a Tax Court decision as an example.

Here, the taxpayer owned a freight terminal and parking lots across the street. The lots were condemned, and since parking facilities were necessary to the terminal’s operations and couldn’t be obtained in the neighborhood, the taxpayer sold the building and bought another with parking facilities. The court concluded the taxpayer was entitled to defer the gain on the sales proceeds.

 

Best Wishes to My Readers for a Happy New Year. As someone who keeps his creditors at bay only because he has a certain talent for demystification of the Internal Revenue Code, I would be remiss in the discharge of my obligations to you were I to fail to note that “year” includes, but is not limited to all calendar, fiscal and taxable years. Consistent with the Joycean murkiness of Code Section 441, “taxable year” includes regular and short taxable years as well as taxable years having 366 days. 

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