General Counsel Memorandum 38968
Internal Revenue Service (I.R.S.)
General Counsel Memorandum (G.C.M.)
Date Numbered: March 9, 1983
April 29, 1982
Section 1033 — Involuntary Conversion
Rev. Rul. 83-49
GERALD G. PORTNEY
Associate Chief Counsel (Technical)
Attention: Director, Corporation Tax Division
In a memorandum dated November 24, 1981, your Office (T:C) requested our concurrence or comments on a proposed revenue ruling (Control No. 8011193243), which was based on a proposal submitted by *** and approved by your Corporation Tax Branch.
ISSUES
1) Under the circumstances described below, can a taxpayer elect to defer, pursuant to I.R.C. Section 1033, the recognition of gain relized from 'severance damages' received as part of a condemnation award?
2) If the taxpayer can elect to defer the recognition of gain, what are the taxpayer's bases in the property retained after the condemnation and in the replacement property?
CONCLUSIONS
1) Pursuant to Rev. Rul. 68-37, 1968-1 C.B. 359, considered by this Office in G.C.M. 33595, Technical Coordination Report 9141, I-2431 (August 17, 1967), a gain of 55x dollars (i.e., 135x dollars, the amount of the severance damages, minus 80x dollars, the basis in the remaining property) was realized from the severance damages. The taxpayer may elect to defer recognition of this gain under section 1033(a)(2), using the 'like kind' standard of section 1033(g).
2) Under Rev. Rul. 68-37, supra, the basis of the remaining portion of the original property is zero. Moreover, in addition to the gain realized on the severance damages, a gain of 35x dollars was realized on property taken. See section 1001. If the taxpayer elects to have its gain deferred, the basis of the replacement property is, under section 1033(b), 260x dollars, representing the cost of the property (350x dollars) reduced by the amount of gain not recognized (90x dollars, i.e., 55x dollars on the severance damages plus 35x dollars on the property taken).
FACTS
The taxpayer purchased agricultural land and buildings to be held for investment purposes for 220x dollars. The taxpayer then leased the property to a farmer. Prior to expiration of the lease, a portion of the property was condemned by state X to make way for an interstate highway. The remaining property was not adequate to sustain a profitable farming operation.
The taxpayer received 175x dollars from state X for the property actually taken and severance damages of 135x dollars for a decrease in value of the retained property. A proper allocation of the taxpayer's basis in the property was 140x dollars to the portion actually taken and 80x dollars to the remaining portion.
Without making an effort to locate iproperty in the same area as the condemned property, the taxpayer, within the prescribed period of time set forth in section 1033, purchased for 350x dollars a large motel complex occupying an area of ground in a city some distance from the former property's location. The taxpayer actively managed and directly operated the motel for its own account.
ANALYSIS
Section 1033(a)(2) provides that if property (as a result of its destruction in whole or in part, theft, seizure or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted into money or into property not similar or related in service or use to the converted property, the gain (if any) shall be recognized except to the extent provided in section 1033(a)(2)(A).
Section 1033(a)(2)(A) specifies that if the taxpayer during the period specified in section 1033(a)(2)(B), for the purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion exceeds the cost of such other property.
Section 1033(g) provides that for purposes of section 1033(a) if real property (not including stock in trade or other property held primarily for sale) held for productive use in trade or business or for investment is (as the result of its seizure, requisition or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted, property of a like kind to be held either for productive use in trade or business or for investment shall be treated as property similar or related in service or use to the property so converted.
Section 1033(b) specifies that in the case of property purchased by the taxpayer in a transaction described in section 1033(a)(2), which resulted in the nonrecognition of any part of the gain realized as the result of a compulsory or involuntary conversion, the basis shall be the cost of such property decreased in the amount of the gain not so recognized.
In its 'Facts', the proposed revenue ruling states that the gain realized from the severance damages received as part of the condemnation award is 55x dollars, i.e., the excess of the damages (135x dollars) over the taxpayer's basis in the remaining land (80x dollars). The ruling then holds that pursuant to section 1033 the taxpayer may elect to defer recognition of this gain. Should the taxpayer make such an election, the ruling continues, his basis in the retained property will be zero, and the excess of the damages over the basis, i.e., 55x dollars, will be applied to reduce his basis in the replacement tract to 260x dollars.
Though its conclusions are more expansive than the Service's current published position and contrary to its previous litigating position, we agree that the proposed ruling provides a correct construction of present law.
Severance damages are paid in a condemnation proceeding to compensate an individual for a decrease in value in property retained by the individual that arises as a result of that property being severed from the condemned property. 3 J. Mertens, Jr., The Law of Federal Income Taxation (1981 rev.). These damages do not constitute an 'amount realized' from the sale of the condemned property for purposes of calculating gain or loss on the sale or exchange thereof. Rather they reduce the basis of the damaged portion, and any excess of the severance damages over basis is taxable gain. See, especially, Pioneer Real Estate Company v. Commissioner, 47 B.T.A. 886, 889 (1942), acq., 1943 C.B. 18, modified 1 T.C.M. 527 (1943) with respect to another issue. Also, Peter Vaira and Mary L. Vaira v. Commissioner, 444 F.2d 770, 774 fn. 6 (3d Cir. 1971), rev'g and rem'g, 52 T.C. 986 (1969), L.A. Beeghly and Mabel L. Beeghly v. Commissioner, 36 T.C. 154, 156 (1961); acq., 1962-1 C.B. 3; and The E.R. Hitchcock Co. v. United States, 514 F.2d 484, (2d Cir. 1975), aff'g, 382 F. Supp. 236 (Conn. 1974).
Though the proposed ruling correctly utilizes this approach in calculating the gain realized with respect to the severance damage award, we believe that the ruling it cites as a basis for doing so, namely, Rev. Rul. 68-37, 1968-1 C.B. 359 (considered by this Office in G.C.M. 33595, Technical Coordination Report 9141, I-2431 (August 17, 1967)), requires some discussion.
Rev. Rul. 68-37, supra, states that it is an amplification of G .C.M. 23698, 1943 C.B. 340 in re *** A-312469, A-312468 (April 17, 1943), which applied an earlier Service position delineated in G.C.M. 20322, 1938-2 C.B. 167, in re *** A-312468, A-312469 (June 16, 1938). G.C.M. 20322 had considered the query whether the proceeds of a condemnation award, including compensation for property taken and severance damages to the remaining plot of real estate, should be reduced by a special assessment for benefits levied against the remaining tract to determine the net award, for federal income tax purposes. In concluding that the award should be so reduced, the G.C.M . had made the general statement that the award should be considered as 'an entirety' for purposes of calculating the Federal income taxes arising from the condemnation proceeding. Applying G.C.M. 20322, G.C.M . 23698, supra, had stated that in spite of the broad wording of G.C.M. 20322, the severance damages were to be deducted solely from the part of the basis of the whole property which was properly allocable to the 'retained portion'. The excess, if any, of the damages over this portion of the basis constituted taxable gain.
Rev. Rul. 68-37, supra, limited the scope of the term 'retained property' as used in G.C.M. 23698. According to Rev. Rul. 68-37, the term only referred to property which had actually been damaged as a result of the condemnation proceeding. Thus where only a portion of the retained property is damaged by the condemnation only the basis attributable to the damaged property is to be reduced by the severance damages. In those circumstances, the gain realized from the severance damages would equal the excess of the damages over the taxpayer's basis in the damaged property.
The motivation for Rev. Rul. 68-37, like G.C.M. 23698 (the memorandum which it amplified), is traceable to G.C.M. 20322. After G.C.M. 20322 was declared to be 'not determinative as to future transactions' by Rev. Rul. 69-45, 1969-1 C.B. 313, the court in LaVonna Conran et al v. United States, 322 F. Supp. 1055, 1057 (E.D . Mo. 1971), held that Rev. Rul. 68p-37 could no longer be regarded as binding authority. Though Rev. Rul. 69-45 would seem to imply that the position laid out in G.C.M. 20322 has been retracted, that is not exactly so.
The administrative file for Rev. Rul. 69-45 states that the G.C.M. was obsoleted because the area encompassed by the memorandum is 'now clearly covered' by Treas. Reg. Section 1.1033(a)-2(c)(10). Treas. Reg. Section 1.1033(a)-2(c)(10) states that '[i]f, in a condemnation proceeding, the Government retains out of the award sufficient funds to satisfy special assessments levied against the remaining portion of the plot or parcel of real estate affected for benefits accruing in connection with the condemnation, the amount so retained shall be deducted from the gross award in determining the amount of the net award.' This was the conclusion in G.C.M. 20322. Rev. Rul. 68-37, while it can no longer be viewed as a clarification of the now defunct G.C.M. 20322, remains viable as a clarification of Treas. Reg. Section 1.1033(a)-2(c)(10) to the extent that regulation might seem to imply that the elements of a condemnation award must be treated as a unit for all federal income tax purposes. Another ruling supporting the basic conclusion of Rev. Rul. 68-37 is Rev. Rul. 68-291, 1968-1 C.B. 351, concluding that where a taxpayer grants an easement that affects only a specific portion of an entire tract, only the basis property allocable to the affected portion is reduced by the consideration received.
We are thus in agreement with the proposed ruling that the taxpayer, pursuant to Rev. Rul. 68-37, has realized a gain of 55x dollars, i.e., the excess of the severance damages (135x dollars) over the taxpayer's basis in the damaged land (80x dollars).
Having determining that the taxpayer has realized gain with respect to the severance damage award, it is now appropriate to determine whether the recognition of this gain is properly deferrable under section 1033. Section 1033(a)(2) permits such a deferral in certain limited circumstances where the gain results from a compulsory or involuntary conversion of property as a result of its destruction in whole or in part, theft, seizure or requisition or condemnation, or threat or imminence thereof.
The gain realized from severance damages has to some extent been allowed section 1033 privileges. Prior to 1980, this eligibility was limited to those instances in which the damages were somehow used to restore the damaged property. G.C.M. 34661 (supp.), *** I-4104 (May 11, 1972), underlying Rev. Rul. 72-433, 1972-2 C.B. 470; Rev. Rul. 69-240, 1969-1 C.B. 199, not considered by this office; Rev. Rul. 60-69, 1960-1 C.B. 294, considered by this office in *** A-620398 (June 17, 1959). In Rev. Rul. 80-184, 1980-2 C.B. 232, considered by this office in G.C.M. 38256, *** I-140-79 (January 25, 1980), the Service published a more expansive rule. Specifically, the gain realized from severance damages is deferrable pursuant to section 1033 where the severance damages were used to buy other property, not to restore the damaged property, so long as it was economically infeasible or impractical to restore the damaged property.
G.C.M. 38256, underlying Rev. Rul. 80-184, had noted the earlier limited eligibility of severance damages for section 1033 treatment. However, relying on Rev. Rul. 72-433, considered by this Office in G.C.M. 34661, *** I-4104 (May 11, 1972), the memorandum concluded that the earlier limitation could be expanded.
Rev. Rul. 72-433 considered condemnation proceeds received by a taxpayer for flowage easement rights on a farm. As a result of the easement, the taxpayer's land would be flooded periodically. There was no way for the taxpayer to prevent or alleviate the flooding. So it was impractical for the taxpayer to reinvest the proceeds in the original land. The taxpayer consequently used the proceeds to purchase second farm so that he could continue to farm at his former capacity despite the floodings. The ruling held that the taxpayer was eligible for a section 1033(a) election even though he had not been deprived of practically all his beneficial rights in the original property prior to his acquisition of the second farm.
In reaching its conclusion, Rev. Rul. 72-433 paralleled the proceeds from involuntary grants of easements with those from severance damages. G.C.M. 38256, underlying Rev. Rul. 80-184, inferred from this that severance damages should be given the same treatment under section 1033 as easements. The G.C.M. then fashioned from Rev. Rul. 72-433 the broad rule which was published as Rev. Rul. 80-184: where a taxpayer can only restore his original rental capacity by purchasing additional land and constructing rental units thereon, the investment in such other property by the taxpayer will not preclude the taxpayer from making an election under section 1033 so long as he has otherwise restored the damaged land to its maximum similar or related use. Though we believe Rev. Rul. 80-184 correctly allowed the taxpayer a section 1033 election under the facts stated therein, we do not believe it was necessary to use such a circuitous route, or design such a constricted rule, to do so.
The basis for the current treatment of severance damages under section 1033(a)(2) is traceable to Rev. Rul. 271, 1953-2 C.B. 36, considered by this office in G.C.M. 27926, *** A-496628 (Aug. 13, 1953). Rev. Rul. 271 considers severance damages awarded to the taxpayer in a condemnation proceeding as a result of damages arising when his land was bisected by a State turnpike. As a result of the bisection, the taxpayer's pasture land was no longer readily accessible to his cattle. The issue in the ruling was, did the expenditure of the damages to convert another part of his farm to pasture and thereby place the farm in the same operating condition as it was prior to the condemnation constitute the acquisition of property similar or related in service or use to the converted property? The ruling held that it did.
The ruling noted that severance damages are analogous to the proceeds of property insurance: they represent compensation for damage to the property. Compare Rev. Rul. 73-35, 1973-1 C.B. 367 (considered by this office in G.C.M. 34991, Severance Damages, I-4193 (Aug. 17, 1972) and Rev. Rul. 68- 37, supra. The ruling indicates that such damages represent compensation for conversion of the taxpayer's right to use his property in the manner and for the purpose for which it was acquired. Later, in Rev. Rul. 73-477, 1973-2 C.B. 302 (considered by this office in G.C.M. 35266, Technical Study Project 65-23, I-5120 (March 14, 1973)), the Service stated that if any insurance contract insures against a lost property right (i.e., the right to use property), nonrecognition treatment under section 1033 is available with respect to the proceeds if the requirements of section 1033 are otherwise satisfied. In light of the analogy drawn in Rev. Rul. 271 between severance damages and insurance proceeds, it follows that taxpayer may elect to defer recognition of gain in respect of severance damages if the requirements of section 1033 are otherwise satisfied.
Moreover, we could find nothing in Rev. Rul. 271 to indicate that section 1033 was intended to be given a less liberal construction. Though the ruling itself does not explicitly state the basis of its holding, G.C.M. 27926, underlying the ruling, does cite two memoranda as support: G.C.M. 21744, *** A-336353 (November 25, 1939) and G.C.M. 20027 *** A-314100 (April 12, 1938).
In G.C.M. 21744 at page 5, this Office had stated that 'the right to use property in the legal manner and for the purpose for which it was acquired, constructed and suitable, is doubtless also 'property', as ordinarily understood and as meant in section 112(f), [the predecessor of section 1033(a).]'.
In G.C.M. 20027, the taxpayer, a manufacturer of clay products, had secured clay for its business from land it owned in the immediate vicinity of its plant. When that land was condemned by the State, the State paid the taxpayer money in settlement of the condemnation proceedings. The taxpayer used the monies to purchase boats and other equipment to transport clay from a new, further away, location. The ruling held that the taxpayer's use of the money to restore its clay business constituted a compulsory or involuntary conversion into property related in service or use to the property converted within the comprehension of 1936 I.R.C. Section 112(f), the predecessor of section 1033(a).
In light of G.C.M. 21744, supra, G.C.M. 27926 at page 2 stated that severance damages are compensation for 'an involuntary conversion of property' within the meaning of 1936 I.R.C. Section 112(f), now section 1033(a). G.C.M. 27926 then cited G.C.M. 20027 as support for its conclusion that the expending of the damages to restore the usability of the farm is a purchase of property 'similar or related in use' to the property converted within the meaning of section 1033(a)(2)(A).
There is nothing in G.C.M. 27926 to indicate that severance damages were to have limited section 1033 status. To the contrary, the G.C.M.'s statement that severance damages are in payment for a taking of property indicates that it was intended that severance damages would come within section 1033 in whatever factual situation a condemnation award for a taking of property could.
This construction of section 1033 is consistent with the Court's statement in Graphic Press, Inc. v. Commissioner, 523 F.2d 585, 589 (9th Cir. 1975), rev'g, 60 T.C. 674 (1973):
It is a legislative recognition that condemnation is not an appropriate time for recognition of gain if there has been no substantial change in form and productive use of an investment and appreciation has not resulted in liquid assets available to pay taxes. Accordingly, unless reimbursement is being made for lost profits, the cases have not scrutinized the source of condemnation proceeds as closely as the taxpayer's reinvestment. (Emphasis added.)
Compare S.H. Kress and Co. v. Commissioner, 40 T.C. 142, 153 (1963); S. & B. Realty Company v. Commissioner, 54 T.C. 863, 871 (1970), acq., 1970-2 C.B. XXI; S.E. Ponticos, Inc. v. Commissioner, 338 F.2d 477, 479 (1964), rev'g and rem'g, 40 T.C. 60 (1963); Clifton Investment Company v. Commissioner, 312 F.2d 719, 723 (6th Cir. 1963), aff'g, 36 T.C. 569 (1961), cert. den'd, 373 U.S. 921 (1963); John Richard Corporation v. Commissioner 46 T.C. 41, 44 (1966), nonacq., 1974-2 C.B. 5, acq . 1967-2 C.B. 3 (withdrawn because the construction the Court placed on section 1033 contravened the literal wording of the statute--see, O.M. 15364, rev. A.O.D., John Richard Corp. (Sept. 12, 1974)); Winter Realty & Construction Company v. Commissioner, 149 F.2d 567, 569-570 (2d Cir. 1945), aff'g in part and rev'g in part, 2 T.C. 38 (1943), nonacq., 1943 C.B. 42 (but see O.M. 5956, A.O.D., Winter Realty and Construction Company (Nov. 21, 1945), recommending publication of the appellate decision.) cert den'd, 326 U.S. 754 (1945); LaVonna Conran et al. v. United States, 322 F. Supp. 1055, 1059 (E.D. Mo. 1971).
Although the Government argued in John L. McKitrick et al. v. United States, 373 F. Supp. 471 (S.D. Ohio 1974) and LaVonna Conran et al. v. United States, 322 F. Supp. 1055 (E.D. Mo. 1971) (both of which it lost) that severance damages basically are not deferrable, we could find nothing in the Code, the regulations, the revenue rulings or our previous memoranda stating a basis for denying severance damages section 1033 coverage as a general rule.
Heretofore we have discussed the threshhold requirement for section 1033: i.e., the requirement that there be a compulsory or involuntary conversion as a result of property being destroyed in whole or in part, stolen, seized, or requisitioned or condemned or the threat or imminence thereof. We have determined that severance damages meet this minimal requirement. We now must ascertain whether a taxpayer seeking to make an election under section 1033 with respect to severance damages must satisfy the stringent 'replacement property' criterion of section 1033(a) or need only meet the more lenient alternative standard in section 1033(g).
In order to come within section 1033(a), the taxpayer must have had his original property compulsorily or involuntarily converted into property that was 'similar or related in service or use to the property so converted.' Section 1033(a)(1). If not, the taxpayer, 'for purposes of replacing the property so converted, must purchase other proerty similar or related in service or use to the property so converted', or he must buy stock in the acquisition of control of a corporation owning such other stock. Section 1033(a)(2). The 'similar or related in service or use' term has been narrowly construed. It has been held not to include improved real estate which is converted into unimproved realty, or city real estate exchanged for a farm or a ranch. S. Rep. No. 1983 85th Cong., 2d Sess. 72 (1958).
Section 1033(g) allows the taxpayer to elect to defer recognition of gain under section 1033(a) if the converted property is replaced by property of a like kind for productive use in trade or business or for investment. The subsection provides for this deferral only, however, in those instances where real property (not including stock in trade or other property held primarily for sale) held for productive use in trade or business or for investment is (as the result of its seizure, requisition, or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted.
We concluded above that severance damages are compensation for the involuntary conversion of property which has been condemned. Assuming the converted property is real property of a character delineated in section 1033(g), recognition of gain arising from severance damages will be deferrable under the subsection if that property is replaced by property of a 'like kind held for productive use in trade or business or for investment.' This conclusion is consistent with the holding in the proposed ruling, which also expands upon the definition of 'like kind'.
In the proposed ruling, the original property was farmland held by the taxpayer in a landlord capacity. When part of this land was condemned, the taxpayer was awarded severance damages to compensate him for injury to his remaining land. Without exploring the possibility of obtaining replacement property in the immediate area of his remaining tract, the taxpayer, for the purpose of replacing the farm, purchased and operated a motel. Because the severance damages exceeded the taxpayer's basis in the remaining and damaged tract by 55x dollars, the taxpayer realized gain to that extent. See our discussion at pages 4-6 above. The ruling considered the query whether this gain was deferrable pursuant to section 1033(g). We must establish two facts in order to reach the proper conclusion.
First, under section 1033(g), the farmland, the original property, must be real property (not including stock in trade or other property held primarily for sale) held for productive use in trade or business or for investment. The farm meets this requirement because it is land (i.e., real property) held for rent (i.e., for investment, but not primarily for sale).
Second, under section 1033(g), the farm must have been replaced by property of a like kind to be held either for productive use in trade or business or for investment. Because the actively managed motel replaced the passively held farm, this raises the issues whether property actively managed for one's own account can be replaced by property held for investment and whether city real estate can replace farmland, in a section 1033(g) 'like kind' exchange.
Treas. Reg. Section 1.1033(g)-1 provides that Treas. Reg. Section 1.1031(a)- 1(b) should be looked to for principles in determining whether replacement property is property of a like kind, for purposes of section 1033(g).
Treas. Reg. Section 1.1031(a)-1(b) specifies that the words 'like kind' have reference to the nature or character of the property and not its grade or guality.
Treas. Reg. Section 1.1031(a)-1(a), applying the principles of Treas. Reg . Section 1.1031(a)-1(b), states that property held for investment may replace property held for productive use in trade or business.
Treas. Reg. Section 1.1031(a)-1(c)(2), also applying the principles of Treas. Reg. Section 1.1031(a)-1(b), provides that a taxpayer who is not a dealer in real estate may exchange city real estate for a ranch or farm .
Pursuant to Treas. Reg. Section 1.1031(a)-1(a), supra, the farm held for investment in the ruling may replace the motel which the taxpayer operates as a trade or business for its own benefit, in a 'like kind' exchange. Pursuant to Treas. Reg. Section 1.1031(a)-1(c)(2), the motel (city real estate) and the farm are 'like kind' property. Thus, the replacement of the passively held farm with the actively managed motel is a 'like kind' conversion within the meaning of section 1033(g). Though the ruling reaches these same conclusions, it cites only John McShain and Mary McShain v. Commissioner, 68 T.C. 154 (1977) and Rev. Rul. 72-549, 1972-2 C.B. 472, not considered in CC:I, as authority. Since there is direct support in the Treasury regulations for its holding on the 'like kind' issue, we would suggest that the ruling also cite these relevant Treasury regulations.
Pursuant to the analysis in this memorandum the taxpayer's tax consequences are as follows. The taxpayer may elect to defer the recognition of gain realized from the severance damages received as a part of the condemnation award. The 135x dollars in damages are to be applied to reduce the taxpayer's basis in the damaged property to zero. 55x dollars, the excess of the damages (135x dollars) over the basis in the damaged property (80x dollars) is the gain realized from the damages. If the taxpayer elects to have this gain deferred under section 1033, his basis in the replacement property, pursuant to section 1033(b), will be 260x dollars: the cost of the replacement property (350x dollars) less the amount of gain not recognized (55x dollars with respect to the property damaged plus 35x dollars with respect to the property taken.). This is consistent with the holdings in the proposed ruling.
However, while we generally are in agreement with the holdings in the ruling, we believe its analysis should include some reference to relevant Treasury regulations. A revised ruling to that effect reflecting the above discussion is attached. In addition, G.C.M. 33595, Technical Coordination Report 9141, I-2431 (August 17, 1967), published as Rev. Rul. 68-37, 1968-1 C.B. 359; G.C.M. 27926, *** A-496628 (August 13, 1953), published as Rev. Rul. 271, 1953-2 C.B. 36; and G.C.M. 38256, *** I-140-79 (January 25, 1980), published as Rev. Rul. 80-184, 1980-2 C.B. 232, are hereby modified to the extent they are inconsistent with the discussion in this memorandum.
GEORGE H. JELLY
Director
By:
RICHARD B. TREANOR
Chief, Branch No. 6
Interpretative Division
Part I
Section 1033 — Involuntary Conversions
26 C.F.R. 1.1033(g)-1: Condemnation of real property held for productive use in trade or business or for investment.
(Also Section 1031; 1.1031-1(b).)
ISSUES
1) Under the circumstances described below, can a taxpayer elect to defer the recognition of gain realized from 'severance damages' received as part of a condemnation award?
2) If the taxpayer can elect to defer the recognition of gain, what are the taxpayer's bases in the property retained after the condemnation and in the replacement property?
FACTS
The taxpayer purchased agricultural land and buildings to be held for investment purposes for 220x dollars. The taxpayer then leased the property to a farmer. Prior to expiration of the lease, a portion of the property was condemned by state X to make way for an interstate highway. The remaining property was not adequate to sustain a profitable farming operation. The taxpayer received 175x dollars from state X for the property actually taken and additional damages of 135x dollars for the reduction in value of the retained property . Damages in addition to an award paid for the property actually condemned when the value of the retained property has decreased as a result of the condemnation are called 'severance damages'. A proper allocation of the taxpayer's basis in the property was 140x dollars to the portion actually taken and 80x dollars to the remaining portion. Therefore, a gain of 35x dollars was realized on the property actually taken, and a gain of 55x dollars was realized on the remaining portion.
Without making an effort to locate property in the same area as the condemned property, the taxpayer, within the prescribed period of time set forth in section 1033 of the Internal Revenue Code, purchased for 350x dollars a large motel complex occupying an acre of ground in a city some distance from the former property's location. The taxpayer actively managed and directly operated the motel for its own account.
LAW AND ANALYSIS
Section 1033(a)(2) of the Code provides that if property, as a result of a condemnation, is compulsorily or involuntarily converted into money, the gain (if any) shall be recognized, except to the extent provided in section 1033(a)(2)(A).
Section 1033(a)(2)(A) of the Code provides that if during a specified period the taxpayer purchases other properties similar or related in service or use to the property so converted, at the election of the taxpayer, the gain shall be recognized only to the extent that the amount realized on the conversion exceeds the cost of such other property.
Section 1033(b) of the Code provides that in the case of property purchased by the taxpayer in a transaction described in section 1033(a)(2) which resulted in the nonrecognition of any part of the gain realized as the result of a compulsory or involuntary conversion, the basis shall be the cost of such property decreased in the amount of the gain not so recognized.
Section 1033(g)(1) of the Code provides that, for purposes of section 1033(a), if real property held for productive use in trade or business or for investment is (as the result of its seizure, requisition, or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted, property of a like kind to be held for either productive use in trade or business or for investment shall be treated as property similar or related in service or use to the property so converted.
Section 1.1033(g)-1 of the Income Tax Regulations provides that the principles set forth in section 1.1031(a)-1(b) of the regulations should be followed in determining whether property is of a like kind for purposes of section 1033(g) of the Code.
Section 1.1031(a)-1(b) of the regulations provides that the words 'like kind' have reference to the nature or character of the property and not its grade or quality. The fact that real estate is improved or unimproved is not material, for that fact relates only to the grade of the property and not to its kind or class.
Section 1.1031(a)-1(a) of the regulations, applying the principles of section 1.1031(a)-1(b) of the regulations, states that property held for investment may replace property held for productive use in trade or business.
Section 1.1031(a)-1(c)(2) of the regulations, also applying the principles of section 1.1031(a)-1(b) of the regulations, provides that a taxpayer who is not a dealer in real estate may exchange city real estate for a ranch or farm.
Rev. Rul. 68-37, 1968-1 C.B. 359, provides that an award of severance damages reduces the basis of the damaged property and any amount received in excess of basis is treated as gain.
Rev. Rul. 69-240, 1969-1 C.B. 199, holds that gain resulting from receipt of severance damages for farmland may qualify for nonrecognition when the severance damages are expended to acquire farm land adjacent to the remaining property to permit continuation of farming operations as before the condemnation.
Rev. Rul. 72-433, 1972-2 C.B. 470, holds that proceeds received under threat of condemnation in return for flowage easement rights on a farm that are reinvested in other farmland qualify for nonrecognition of gain under section 1033 of the Code. In reaching this holding the revenue ruling states that there is a close similarity between the nature of proceeds from the involuntary grant of an easement and the severance damages for the loss in value of retained land resulting from a condemnation. The revenue ruling notes that in both situations a property owner retains property that has been affected in some way by the condemnation of related property.
In Rev. Rul. 72-549, 1972-2 C.B. 472, the taxpayer, under threat of condemnation, granted an electric power company an easement and right-of-way over property used in the taxpayer's trade or business. The facts indicate that the property involved was unimproved real property. Subsequently, the taxpayer purchased, for an amount in excess of the amount received from the power company, real property with nominal rental improvements and real property with an apartment building. Both properties were held either for productive use in the trade or business or for investment by the taxpayer. The revenue ruling concludes that the easement and right-of-way that the taxpayer granted and the real estate properties that the taxpayer acquired are both continuing interests in real property and of the same nature and character, and as such qualify as 'like kind' property under sections 1031 and 1033(g) of the Code. Thus, both properties acquired by the taxpayer qualify as replacement property for purposes of section 1033.
In McShain v. Commissioner, 68 T.C. 154 (1977), the taxpayer received a condemnation award and elected to replace the condemned property with like kind property. Subsequently, upon realizing that for federal income tax purposes it was not advantageous to defer recognition of the gain, the taxpayer sought to revoke a prior election under section 1033 of the Code by contending that the replacement property was not a valid replacement for the condemned property. The condemned property was originally unimproved realty leased by the taxpayer. While title to improvements erected by the lessee passed to the taxpayer upon expiration of the lease, the taxpayer's investment in the condemned property remained a passive one in which the taxpayer had no major obligations or duties. In contrast, the replacement property was a motor inn constructed, actively managed, and directly operated by the taxpayer. The taxpayer argued that the replacement property was not 'similar or related in service or use' to the condemned property within the meaning of section 1033(a)(2)(A), and the Internal Revenue Service did not contest this point. Rather, the Service asserted that nonrecognition was authorized because the replacement property was 'like kind' property within the meaning of section 1033(g). The court concluded that the taxpayer had replaced the condemned property with like kind property noting that, under the regulations, property held for investment may be exchanged for property held for productive use in trade or business.
Rev. Rul. 72-433 indicates that severance damages and proceeds received for the involuntary grant of an easement should be treated the same for federal income tax purposes. In Rev. Rul. 72-549, nonrecognition under section 1033(g) of the Code was afforded to a taxpayer that invested the proceeds received for the granting of an easement over unimproved real property in improved real property. Similarly, section 1033(g) can be utilized to afford relief in the severance damages context of the present case. McShain is illustrative of the less stringent 'like kind' test under section 1033(g). The present case is similar to Rev. Rul. 72-549 and McShain. Like the taxpayers in those situations, the taxpayer in the present case invested proceeds realized as a result of a condemnation of property not similar or related in service or use to the condemned property. However, the taxpayer's investment of the proceeds realized from the condemnation of agicultural property held as a passive investment in an urban complex, actively managed and operated by the taxpayer, constitutes a continuing interest in real property. Since the replacement property is of the same nature as the condemned property, within the meaning of section 1.1031(a)-1(b) of the regulations, and is held by the taxpayer for investment or productive use in a trade or business, the replacement property qualifies as property of a like kind within the meaning of section 1033(g).
HOLDINGS
1) The taxpayer may elect to defer recognition of gain realized from the severance damages received as a part of a condemnation award.
2) The basis of the remaining portion of the original property is zero. If the taxpayer elects to have its gain deferred, the basis of the replacement property is, under section 1033(b) of the Code, 260x dollars, representing the cost of the property (350x dollars) reduced by the amount of gain (90x dollars) not recognized.
EFFECT ON OTHER REVENUE RULING
Rev. Rul. 271, 1953-2 C.B. 36, holds that gain resulting from receipt of severance damages qualifies for nonrecognition under the predecessor of section 1033 of the Code when the severance damages are used to restore the retained property to its former condition. The revenue ruling also provides that gain will be recognized to the extent that the unexpended portion of such damages exceeds the basis of the retained property. To the extent that it holds that only the unexpended portion of severance damages are applied to reduce a taxpayer's basis in the remaining portion of the original property, Rev . Rul. 271 is modified.
Rev. Rul. 80-184, 1980-2 C.B. 232, to the extent it implies that the nonrecognition provisions of section 1033 of the Code would not apply where severance damages are expended to acquire new property unless there were a showing that it was not economically feasible or practical to invest any more funds in the retained property, is modified.
This document is not to be relied upon or otherwise cited as precedent by taxpayers.
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