18.23 Types of Qualifying Replacement Property

Although exact duplication is not required, the replacement generally must be similar or related in service or use to the property that was involuntarily converted in order to defer tax. Where real property held for productive use in a business or for investment is converted through a condemnation or threat of condemnation, the replacement test is more liberal. A replacement merely has to be of a like kind to the converted property.

Under the like-kind test for condemned real estate, a replacement with other real estate qualifies. Improved real property may be replaced by unimproved real property (6.1). Foreign and U.S. real property are considered to be of like kind for purposes of replacing condemned property, even though under the like-kind exchange rules (6.1), U.S. real estate and foreign real estate are not considered like-kind property.

Under the related-service/use test, the replacement of unimproved land for improved land does not qualify. A replacement generally must be closely related in function to the destroyed property. For example, a condemned personal residence must be replaced with another personal residence. The replacement of a house rented to a tenant with a house used as a personal residence does not qualify for tax deferral; the new house is not being used for the same purpose as the condemned one. This functional test, however, is not strictly applied to conversions of rental property. Here, the role of the owner toward the properties, rather than the functional use of the buildings, is reviewed. If an owner held both properties as investments and offered similar services and took similar business risks in both, the replacement may qualify.

You may own several parcels of property, one of which is condemned. You may want to use the condemnation award to make improvements on the other land such as drainage and grading. The IRS generally will not accept the improvements as a qualified replacement. However, an appeals court has rejected the IRS approach in one case.

If it is not feasible to reinvest the proceeds from the conversion of livestock because of soil contamination or other environmental contamination, then other property (including real property) used for farming purposes is treated as similar or related and qualifies as replacement property.

Deferral may be barred when buying a replacement from a relative.

The gain deferral rules do not apply if you buy a replacement from a close relative or a related business organization unless the total gain you realized for the year on all involuntary conversions on which there are realized gains is $100,000 or less. In determining whether gains exceed $100,000, gains are not offset by losses. Affected related parties are the same as defined for loss transactions discussed in 5.6.

Caution

Buying Replacement From Relative

Buying a replacement from a relative or related business organization will not defer gain unless total gains from involuntary conversions for the year are $100,000 or less.

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Buying controlling interest in a corporation.

The replacement test may be satisfied by purchasing a controlling interest (80%) in a corporation owning property that is similar or related in service to the converted property.

Business and investment property in a disaster area.

The similar or related-use tests do not have to be met when replacing business or investment property damaged or destroyed in a federally declared disaster area. You may make a qualified replacement by buying any tangible property held for business use.