18.24 Cost of Replacement Property Determines Postponed Gain

To fully defer tax on the replacement of involuntarily converted property (18.20), the cost of the replacement property must be equal to or exceed the net proceeds from the conversion. If replacement cost is no more than the adjusted basis of the converted property, you report the entire gain. If replacement cost is less than the amount realized on the conversion but more than the basis of the converted property, the difference between the amount realized and the cost of the replacement is reported as gain; you may elect to postpone tax on the balance of the gain. See Examples 1–3 below.

Condemnation award.

The award received from a state authority may be reduced by expenses of getting the award such as legal, engineering, and appraisal fees. The treatment of special assessments and severance damages received when part of your property is condemned is explained below (18.25). Payments made directly by the authority to your mortgagee may not be deducted from the gross award.

Do not include as part of the award interest paid on the award for delay in its payment; you report the interest as interest income. The IRS may treat as interest part of an award paid late, even though the award does not make any allocation for interest.

Relocation payments are not considered part of the condemnation award and are not treated as taxable income to the extent that they are spent for purposes of relocation; they increase basis of the newly acquired property.

Distinguish between insurance proceeds compensating you for loss of profits because of business interruption and those compensating you for the loss of property. Business interruption proceeds are fully taxed as ordinary income and may not be treated as proceeds of an involuntary conversion.

A single standard fire insurance policy may cover several assets. Assume a fire occurs, and in a settlement the proceeds are allocated to each destroyed item according to its fair market value before the fire. In comparing the allocated proceeds to the tax basis of each item, you find that on some items, you have realized a gain; that is, the proceeds exceed basis. On the other items, you have a loss; the proceeds are less than basis. According to the IRS, you may elect to defer tax on the gain items by buying replacement property. You do not treat the proceeds paid under the single policy as a unit, but as separate payments made for each covered item.