18.20 Involuntary Conversions Qualifying for Tax Deferral

For purposes of an election to defer tax on gains, “involuntary conversion” is more broadly defined than “casualty loss.” You have an involuntary conversion when your property is:

Damaged or destroyed by some outside force.

Stolen, seized, requisitioned, or condemned by a governmental authority.

If you voluntarily sell land made useless to you by the condemnation of your adjacent land, the sale may also qualify as a conversion. Condemnation of property as unfit for human habitation does not qualify. Condemnation, as used by the tax law, refers to the taking of private property for public use, not to the condemnation of property for noncompliance with housing and health regulations. Similarly, a tax sale to pay delinquent taxes is not an involuntary conversion.

Sold under a threat of seizure, condemnation, or requisition.

The threat must be made by an authority qualified to take property for public use. A sale following a threat of condemnation made by a government employee is a conversion if you reasonably believe he or she speaks with authority and could and would carry out the threat to have your property condemned. If you learn of the plan of an imminent condemnation from a newspaper or other news media, the IRS requires you to confirm the report from a government official before you act on the news.

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image Filing Tip
Sale of Property Under Hazard Mitigation Program
A sale or other transfer of vulnerable property to federal, state, or local authorities (or Indian tribal governments) under a hazard mitigation program is treated as an involuntary conversion, thereby allowing a gain to be deferred if a qualifying replacement (18.19) is made.
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Farmers.

Farmers also have involuntary conversions when:

Land is sold within an irrigation project to meet federal acreage limitations;
Cattle are destroyed by disease or sold because of disease; or
Draft, breeding, or dairy livestock is sold because of drought. The election to treat the sale as a conversion is limited to livestock sold over the number that would have been sold but for the drought.
In some cases, livestock may be replaced with other farm property where there has been soil or other environmental contamination.

Should you elect to postpone gain?

An election gives an immediate advantage: tax on gain is postponed and the funds that would have been spent to pay the tax may be used for other investments.

However, as a condition of deferring tax, the basis of the replacement property is generally fixed at the same adjusted basis as the converted property. If your reinvestment exceeds the insurance proceeds, the excess increases the basis of the replacement property. As long as the value of the replacement property does not decline, tax on the original gain is finally incurred when the property is sold.

If your home was destroyed in a federally declared disaster area, and you have a gain that is not excludable under the home exclusion rules (Chapter 29), the gain may be excludable or deferrable under the special rules discussed in 18.3 under the heading “Insurance Proceeds for Damaged or Destroyed Residence.”

EXAMPLE
Assume a rental building is destroyed by fire and a proper replacement is made. Assume that gain on the receipt of the insurance proceeds is taxable as capital gain. An election is generally not advisable if you have capital losses to offset the gain. However, even if you have no capital losses, you may still decide not to make the election and pay tax in order to fix, for purposes of depreciation, the basis of the new property at its purchase price, if the future depreciation deductions will offset income taxable at a higher rate than the current tax. If there is little or no difference between the two rates so that a net after-tax benefit from the depreciation would not arise, an election might be made solely to postpone the payment of tax.
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image Planning Reminder
Basis Reduction
Consider whether postponement of gain at the expense of a reduced basis for property is advisable, compared to the tax consequences of reporting the gain in the year it is realized.
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