March 28th, 2016 — By — In Articles
Understanding the Tax Consequences of Condemnation
When a government agency or other entity with the power of eminent domain acquires or condemns private property, the private owner is entitled to “just compensation” for the value of the property taken. This compensation – or at least the majority of it – is essentially paid as the purchase price for the condemned property. Eminent domain involves the transfer of real estate title in exchange for the payment of compensation which the Internal Revenue Code (the “Code”) generally treats as an ordinary taxable sale of property.
This means, as you might expect, that the Internal Revenue Service (IRS) considers the just compensation received by a property owner as a “gain” for which taxes should be paid. While the proceeds from condemned property are generally subject to taxation, the Code contains an important nonrecognition provision in Section 1033 which allows for certain exceptions to taxation for property taken by eminent domain.
Section 1033: Involuntary Conversions – Nonrecognition of Gains from the Transfer of Condemned Property
As a general rule, when a private property owner voluntarily sells a piece of real estate, he or she has the opportunity to reinvest the proceeds from the sale into like property and avoid paying income tax on the gains from the sale. This rule for voluntary sales exists under Section 1031 of the Code, and is why you generally do not have to pay income tax when you sell your house and use the proceeds to buy a new home.
- Their property is condemned, or there is a “threat of imminence” of condemnation;
- They replace the condemned property within a specified time period (typically two to three years); and,
- The replacement property is “eligible property” (similar to the like-kind provision in Section 1031) under Section 1033.
Forms of Compensation Not Eligible for Nonrecognition under Section 1033
While it is important for property owners facing condemnation to be familiar with the exceptions established in Section 1033, they need to understand the limitations as well. Although Section 1033 provides for nonrecognition of certain gains from the forced sale of property in eminent domain, it does not apply to all compensation received pursuant to a condemnation. Some of the forms of compensation that may not be eligible for nonrecognition under Section 1033 include:
- Interest, including detention damages, delay damages and payments for delay in compensation
- Lost business profits that would be treated as ordinary income
- Compensation for destruction of property (under applicable circumstances)
- Relocation costs and other expenses
In many cases, property owners will receive a lump sum condemnation award, which can make it difficult to allocate the compensation received into different tax buckets. As a result, before when accepting an award of just compensation or a condemnation settlement, it is important to discuss the tax ramifications with an experienced tax advisor or attorney.
Condemnation of private property can sometimes lead to income tax consequences, however, the exceptions for involuntary conversions in Section 1033 of the Code can benefit property owners who are forced to sell their property under threat of eminent domain or through condemnation proceedings. Losing property in this way can be stressful and confusing. Likewise, the provisions of Section 1033 can be confusing and complex. If you are facing condemnation or are navigating eminent domain proceedings, it is crucial that you take action to qualify under the requirements of 1033 and any other specific tax code sections that may apply to your situation. Consider consulting with a professional tax advisor or an experienced eminent domain attorney to ensure that you understand the tax implications involved in an involuntary conversion of your property due to eminent domain.
Owners’ Counsel of America | Leading Eminent Domain Attorneys Nationwide
Owners’ Counsel of America (OCA) is a network of the nation’s leading eminent domain attorneys who represent private property owners in matters involving eminent domain, inverse condemnation, regulatory takings and property rights claims. If the government is trying to take your property, contact us to speak with an eminent domain lawyer in your state today.