Published November 2004

‘Involuntary conversion’ can bring tax breaks

By Mary Decker
Guest Columnist

When it comes to the International Speedway Corp.’s NASCAR proposal, some landowners in north Marysville are not going without a fight. Others might just be jumping for joy.

That’s because of a little-known provision in the tax code called “involuntary conversions.” If enough owners of the affected land are not willing to sell their property for the development, Snohomish County and Marysville could try to force them out using what is known as “eminent domain.” This action may qualify the owners for a special tax break on the sale.

“Eminent domain” means a government has decided to acquire property for public use, and is authorized to condemn the property if a voluntary sale is not arranged. The sale of the property, voluntary or involuntary, is considered an “involuntary conversion.” Under these conditions, the owner can sell his property and, if he replaces it within the required timeframe, defer all of the tax on the sale, maybe forever.

Internal Revenue Code Section 1033 provides that if property is involuntarily converted into property similar or related in service or use to the property that’s being converted, no gain shall be recognized. Unlike the “like-kind exchange” rules, this tax break is available for personal residences as well as investment or business use. You can pocket the cash, as long as you spend it later on replacement property. Generally, you have until two years after the end of the year of sale (three years if the property was investment or business use) to reinvest the money.

Your personal residence may already qualify for the exclusion of $250,000 ($500,000 for joint filers) in gains. But some rural landowners in Snohomish County could be looking at gains far in excess of $500,000 if they have owned the property long enough. If you qualify, you can use both provisions, deferring the gain in excess of the excludable amount.

The replacement property must be “similar or related in service or use,” which means that a personal residence would need to be replaced with another personal residence. There is a more liberal “like kind” requirement for business use or investment property under condemnation or threat thereof. One could conceivably sell the farm and buy an office building, or even raw land.

As long as the amount realized (sale price minus expenses but not debts paid off) is reinvested this way, the gain can be deferred. To the extent you fall short, you must recognize and pay tax on the gain. Your tax basis in the new property gets adjusted downward for the deferred gain. However, permanent avoidance of the capital-gains tax may be achieved if you hold onto the new property until your death. Then it gets a “step up” in basis to its fair-market value at the time of death.

You elect to defer the gain on your tax return by attaching certain required information and not paying the tax. If you think you may qualify, be sure to seek out a qualified tax adviser for specific advice on how to handle your particular circumstances.

Mary Decker, a shareholder with Hascal, Sjoholm & Co. P.S. in Everett, is a certified public accountant and a certified financial planner. She can be reached at 425-252-3173 or by e-mail to maryd@hascal.com.

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