Taxpayers should be aware of the potential income tax and property tax planning opportunities available if a public agency takes their real property through condemnation or similar means. In such scenarios, with proper planning, a taxpayer can defer income taxes and avoid or minimize increased property tax when they acquire replacement property. This is especially important when the taxpayer’s income tax basis in the property and property tax base value are low.
Possible Income Tax Benefits. Internal Revenue Code Section 1033 allows taxpayers to defer gain on the disposition of property (including real property) which is “involuntarily converted.” Involuntary conversion includes destruction, theft, seizure, acquisition or condemnation or the threat or imminence of condemnation. Generally, if property is converted into money, the taxpayer does not recognize gain on the disposition to the extent the taxpayer purchases other property “similar or related in service or use” to the converted property within a certain time period.
A special rule applies to real property held for productive use in a trade or business or for investment. This rule allows taxpayers holding such real property to acquire replacement property of a “like-kind” beginning as early as the earliest date of the threat or imminence of condemnation and ending three (3) years after the close of the first taxable year in which any part of the gain upon the conversion is realized. This provides taxpayers with a significant amount of time to locate and acquire suitable replacement property.
To take advantage of the tax benefits of Section 1033, the taxpayer must report an intention to defer any gain realized from the condemnation of the property in the tax return for the year the condemnation award or sales proceeds are received. The tax return must include details of the condemnation along with a statement that the gain is not being included in gross income.
Possible Property Tax Benefits. California law requires reassessment of property for property tax purposes if there is a “change in ownership” of the property. Generally, when a person buys real property in California, the property tax base is equal to the fair market value of the property. However, a person acquiring new property after being displaced through eminent domain, public entity acquisition, or inverse condemnation may be able to carry over their property tax base in the property relinquished to the new replacement property. Careful planning is necessary to maximize this benefit.
This carryover of the property tax base applies only if the replacement property is “comparable” to the relinquished property. Property is deemed “comparable” if it is similar in size, utility and function to the relinquished property. Property is similar in function if it is subject to similar governmental restrictions, such as zoning. Property is similar in size and utility only if the replacement property is used or intended to be used in the same manner as the property taken (e.g. agricultural, residential, industrial, etc.) and its full cash value does not exceed 120% of the condemnation award or the payment for the relinquished property.
For more information on this and other real property tax planning issues, contact Troy Kingshaven, Esq. of Fenton & Keller’s Business, Real Estate and Tax Team.
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