18.22 Time Period for Buying Replacement Property
To defer tax, you generally must buy property similar or related in use (18.23) to the converted property within a fixed time period. The replacement period is either two, three, four, or five years:
1. A two-year replacement period applies for destroyed, damaged, or stolen property, whether used for business, investment, or personal purposes, but there is a four-year period for principal residences in federally declared disaster areas (18.3). The two-year period for damaged, destroyed, and stolen property starts on the date the property was destroyed, damaged, or stolen, and ends two years after the end of the first year in which any part of your gain is realized. A two-year period also applies to a condemned residence.
2. A three-year replacement period applies for condemned business or investment real estate, excluding inventory. However, the two-year and not the three-year period applies if the condemned business or investment real estate is replaced by your acquiring control of a corporation that owns the replacement property.
3. A four-year replacement period applies for a principal residence or its contents involuntarily converted as a result of a federally declared disaster (18.3). The four-year replacement period starts on the date the residence is involuntarily converted and ends four years after the end of the first taxable year in which any part of the gain is realized.
4. A five-year replacement period applies for property damaged or destroyed by Hurricane Katrina (2005) or in the 2007 Kansas disaster area or the 2008 Midwestern disaster area, but only if substantially all of the use of the replacement property is in the applicable disaster area. The five-year period ends five years after the end of the first taxable year in which any part of your gain is realized.
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Planning Reminder
Extension of Time To Replace
Within the time limits, you must buy replacement property rather than merely contracting to do so. If you cannot replace property within the time required, ask your local IRS area director for additional time. Apply for an extension before the end of the period. If you apply for an extension within a reasonable time after the statutory period has run out, you must have a reasonable cause for the delay in asking for the extension.
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Replacing condemned property.
For condemnations, the replacement period starts on the earlier of (1) the date you receive notification of the condemnation threat or (2) the date you dispose of the condemned property. Depending on the replacement period (see above), the period ends two, three, four, or five years after the end of the first year in which any part of the gain on the condemnation is realized. You may make a replacement after a threat of condemnation. If you buy property before the actual threat, it will not qualify as a replacement even though you still own it at the time of the actual condemnation.
EXAMPLES
1. On January 12, 2012, a parcel of investment real estate is condemned; the parcel cost $15,000. On March 16, 2012, you received a check for $23,500 from the state. You may defer the tax on the gain of $8,500 if you invest at least $23,500 in other real estate not later than December 31, 2015, the end of the three-year replacement period.
2. Business property was contaminated by dangerous chemicals, and after the Environmental Protection Agency ordered businesses and residents to relocate, the property was sold to the local government under a threat of condemnation. The owner was paid the full pre-contamination fair market value for the property. The owner wanted to defer gain under the three-year replacement rule for condemnations. However, the IRS said that part of the gain was deferrable under the two-year rule and part under the three-year rule. There were two conversions: (1) the contamination, subject to the two-year replacement rule; and (2) the later condemnation, subject to the three-year rule.
To determine the amount eligible for deferral for each period, an allocation must be made between the proceeds allocable to the destruction of the property and the proceeds allocable to the condemnation.
According to the IRS, the burden for making the allocation between the two conversions rests with the owner. The government’s payments are allocable to the condemnation and, therefore, eligible for the three-year replacement rule, only to the extent of the post-contamination value. Practically speaking, it may be advisable to make the replacement within the two-year period, as it may be difficult to show the contaminated land had any value after the contamination.
Advance payment of award.
Gain is realized in the year compensation for the converted property exceeds the basis of the converted property. An advance payment of an award that exceeds the adjusted basis of the property starts the running of the replacement period.
An award is treated as received in the year that it is made available to you without restrictions, even if you contest the amount.
Replacement by an estate.
A person whose property was involuntarily converted may die before he or she makes a replacement. According to the IRS, his or her estate may not reinvest the proceeds within the allowed time and postpone tax on the gain. The Tax Court rejects the IRS position and has allowed tax deferral where the replacement was made by the deceased owner’s estate. However, the Tax Court agreed with the IRS that a surviving spouse’s investment in land did not defer tax on gain realized by her deceased husband on an involuntary conversion of his land. She had received his property as survivor of joint tenancy and could not, in making the investment, be considered as acting for his estate.
Giving IRS notice of replacement.
If you have not bought replacement property by the time you file your return for the year of the involuntary conversion but you intend to do so, attach a statement to your return describing the conversion and the computation of gain, and state that you intend to make a timely replacement. Then, on the return for the year of replacement, attach a statement giving the details of your replacement property. This notice starts the running of the period of limitations for any tax on the gain. Failure to give notice keeps the period open. Similarly, a failure to give notice of an intention not to replace also keeps the period open. When you do not buy replacement property after making an election to postpone tax on the gain, file an amended return for the year in which gain was realized and pay the tax (if any) on the gain.
Assume you have a gain from an involuntary conversion and do not expect to reinvest the proceeds. You report the gain and pay the tax. In a later year, but within the prescribed time limits, you buy similar property. You may make an election to defer tax on the gain and file a claim for tax refund.
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Caution
Nullifying Deferral Election on Amended Return
If you elect to defer tax on a gain, intending to buy replacement property, but you fail to make a replacement within the time limit, you must file an amended return for the year of the gain and pay the tax that you had elected to defer. You also must file an amended return and report the gain not eligible for deferral if you invest in property that does not qualify as a replacement, or which costs less than the amount realized from the involuntary conversion.
However, if you elect to defer and make a timely qualifying replacement, you may not change your mind and pay tax on the gain in order to obtain a higher basis (18.20) for the replacement property. The Tax Court has agreed with the IRS that the election to defer is irrevocable once a qualified replacement is made within the time limits. Similarly, once you acquire qualified replacement property and designate it as such in a statement (18.22) attached to your tax return, you may not substitute other replacement property, even if the replacement period has not yet expired.
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