General Counsel Memorandum 39182
Internal Revenue Service (I.R.S.)
General Counsel Memorandum (G.C.M.)
Date Numbered: March 6, 1984
October 6, 1982
Section 118 -- Contributions to the Capital of a Corporation
Section 1033 -- Involuntary Conversion
IN RE: WHETHER A TAXPAYER'S RIGHT TO THE EXCLUSIVE USE OF ITS RAILROAD TRACK IS 'PROPERTY' UNDER SECTION 1033. WHETHER INVOLUNTARY IMPROVEMENTS TO THE TRACK TO HANDLE ADDITIONAL TRAFFIC QUALIFY AS REPLACEMENT PROPERTY
TO: GERALD G. PORTNEY
Associate Chief Counsel (Technical)
Attention: Director, Corporation Tax Division
The Corporation Tax Division, in a memorandum dated March 9, 1982, requested our consideration of a ruling request in the above-named case
1.Whether the taxpayer's right to exclusive use of its railroad track is 'property' within the meaning of I.R.C. section 1033.
2.Whether involuntary improvements to the same track, to handle additional traffic, qualify as 'replacement property' under section 1033.
You have tentatively concluded that a taking of the taxpayer's exclusive right to use of railroad track is not 'property' within the meaning of section 1033 because the taxpayer has not parted with any of its income producing track and may in fact gain rental income, offset to some extent by increased maintenance costs. You have further concluded that involuntary improvements to the same track to handle additional traffic do not qualify as replacement property under section 1033, although you note that the taxpayer appears to meet the spirit of section 1033 and fails only on the formal requirements of the section.
We disagree with your conclusion that the taxpayer does not meet the requirements for the deferral of recognition of gain under section 1033. We find both that the taxpayer has suffered a taking of property within the meaning of section 1033 and that the investment of damages paid by the state in improvements to the track in the manner described will constitute an investment in replacement property that meets the requirements of section 1033.
You indicate that you have not considered the application of section 118 and that the administrative section handling this ruling would not consider a section 118 question. You have further indicated that both the taxpayer and the state resist consideration under this section. We have, therefore, limited our consideration to the two issues set forth in your memorandum.
In order to build an interstate highway, the State of * * * proposes to displace the * * * railroad (not the taxpayer) from its yard and build the highway through the spot now occupied by the yard. * * * under threat of condemnation, intends to obtain a 'joint use agreement' permitting the displaced railroad to share use of 12 to 16 miles of the taxpayer railroad's track * * *. The taxpayer has submitted a statement from the Attorney General's office for the State of * * * indicating its belief that the state has the power, under case law and statute, to effect such a condemnation of railroad property in * * * through the exercise of its powers of eminent domain. The taxpayer further asserts that it has been notified by counsel for the state department of transportation that in the event of the taxpayer's failure to agree to joint use with * * *, the state would commence eminent domain proceedings.
The taxpayer currently has exclusive rights to use its track from * * * to * * * passing through * * *. It uses these rails to haul * * * and * * * to * * *. The track is light weight rail sufficient for the taxpayer's purposes. In order to adapt the * * * track for joint use, heavier track must be laid, improved signals placed, centralized traffic control installed and banking done to accommodate the longer heavier cars used by * * *.
Under the joint use agreement, the taxpayer would grant * * * a non-exclusive permanent easement on the track in question. The taxpayer would continue to own the track and would pay for increased maintenance but would receive a rental fee from * * * which would include, but not be limited to, its proportionate share of operation and maintenance costs. * * * would pay the costs for initial improvements, construction of the yard and necessary track improvements. However, the upgrading of the track, while paid for by * * * would be done by taxpayer with its own employees. Taxpayer would also receive a small overpass presently owned by the State of * * * and suitable for snowmobile use. The overpass would enable the taxpayer to conform to a * * * recreation law requiring that snowmobiles must be given access to a means of crossing railroad tracks at designated mileage intervals. The overpass could not be used for any other purpose.
As a result of joint use, the * * * would run approximately * * * cars out and back on a daily basis. [FN3] The first train on the track, whether the taxpayer's or * * * would have the right of way. Furthermore, the taxpayer would be required in perpetuity to maintain the track and to obtain permission from the displaced railroad before selling or abandoning the track.
As part of the proposed plan, the State of * * * intends to build a replacement railroad yard for * * * on * * * acres of land adjacent to the tract in * * *. The taxpayer owns approximately * * * acres of the land affected and is not presently using the acreage. The State of * * * has indicated that in order to implement their plans, ownership of the land must be transferred to * * * in return for a payment equivalent to the fair market value of the land.
The State of * * * indicated in conference that it would be relying on federal funds and that it believes it is therefore limited to the payment of relocation expenses and that it cannot make a capital contribution to a railroad.
Section 61(a) provides that, in general, except as otherwise provided in this subtitle, gross income means all income from whatever source derived.
Section 1033(a) provides that if property, as a result of its destruction in whole or in part, is compulsorily or involuntarily converted into property similar or related in service or use to the property converted, no gain will be recognized. When the property is converted into money, the gain shall be recognized except as provided in section 1033(a)(2)(A).
Section 1033(a)(2)(A) provides that if, during a specified period, the taxpayer 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 exceeds the cost of such other property. Similarly, Treas. Reg. section 1.1033(a)-2(c) provides that if property, as a result of its destruction in whole or in part, is involuntarily converted into money, any gain shall be recognized, at the election of the taxpayer, only to the extent that the amount realized upon such conversion exceeds the cost of the replacement property, if such property is similar or related in service or use to the property so converted.
In addition, with respect to real property held for productive use in trade or business, section 1033(g) provides that for the purposes of subsection (a), when such real property is compulsorily or involuntarily converted, property of a like kind to be held for productive use in trade or business or for investment will be treated as property similar or related in service or use to the property so converted.
I. AVAILABILITY OF NONRECOGNITION OF GAIN UNDER SECTION 1033
A. The * * * Land--Requirement for Threat or Imminence of Condemnation
Neither the taxpayer's briefs nor the presentation of issues by your division raise questions with respect to the * * * land. We assume this is a result of the fact that the land, if taken or sold under threat of condemnation, is clearly property within the meaning of section 1033 and the fact that we have no information about the replacement property, if any, in which the amount received for the land will be invested.
For both of these presumed reasons, we have limited our response in the remainder of the G.C.M. to the section 1033 issues raised with respect to the involuntary conversion of the taxpayer's right to exclusive use of a portion of its railroad track. We do note, however, that the applicability of section 1033 deferral of recognition of gain on the * * * land will require an initial determination that any sale was made under threat of condemnation.
The use of the term 'threat' is indicative of the fact that the statute does not require the possibility of condemnation to be reduced to a certainty. See S. & B. Realty Company v. Commissioner, 54 T.C. 863 (1970), acq., 1970-2 C.B. XX1; Rev. Rul. 81- 180, 1981-2 C.B. 66; Rev. Rul. 63-221, 1963-2 C.B. 332; Rev. Rul. 58-557, 1958-2 C.B. 402.
Both revenue rulings 58-577 and 63-221 were modified and expanded by Rev. Rul. 74-8, 1974-1 C.B. 200, considered in G.C.M. 35249 (Supp.), * * *, I-4900 (May 11, 1973), to provide that a threat or imminence of condemnation may also exist for purposes of section 1033 even if the named condemning authority does not have actual authority to condemn property for public use prior to or at the time of sale, if the named condemning authority could readily obtain such authority in the event that a voluntary sale is not arranged. In Rev. Rul. 74-8 the sale was to a public utility that, generally, could readily obtain the power to condemn by application to the appropriate state official. The ruling notes that there was no reason to believe that such power to condemn would be denied. G.C.M. 35249 (Supp.), supra., states this rule is inapplicable if the taxpayer has, or reasonably should have, knowledge that this power to condemn cannot be readily obtained.
In the present case, while * * * has no power to effect a condemnation of land in * * * through the exercise of its power of eminent domain, it has indicated that it will, if necessary, petition the United States Secretary of Commerce to acquire the * * * land under its statutory powers of condemnation and eminent domain. The power vested in the Secretary arises from title 23, U.S. Code section 107, which provides, in pertinent part, that when a state is unable to acquire lands or interest in lands necessary for purposes connected with the prosecution of any project for the construction of any section of the Interstate Highway System, the state may make application to the U.S. Secretary requesting that he acquire the needed property in the name of the United States by purchase, donation, condemnation or otherwise.
We believe that the rationale in G.C.M. 35249 (Supp.) and Rev. Rul. 74-8 can reasonably be extended to a situation in which the threatening party cannot itself obtain the power to take by condemnation but does have statutory authority to request that another government entity, endowed with such statutory authority, proceed to take the land under its powers of condemnation. However, this result would not apply, unless the taxpayer could evidence that, generally, the threatening party would be able to cause the entity empowered to condemn to exercise its power and that the taxpayer reasonably believed that this invoking of the power to condemn would be successful. We do not have sufficient facts at the present time to determine the State's likelihood of success should it request the U.S. Secretary of Commerce to act. Should the taxpayer sell the * * * land and reinvest the gain in replacement property that meets the requirements of section 1033 a determination of the existence or nonexistence of a threat should be made consistent with the test set forth here.
B. Whether Right of Exclusive Use is Property Within the Meaning of Section 1033
The taxpayer has asserted that under the proposed state plan it would lose its exclusive right to use of about * * * miles of its track . In addition, some of the taxpayer's light duty track would be modified to accommodate heavier longer cars used by * * *. The Corporation Tax Division has stated, and the taxpayer's briefs suggest, that the primary loss is that of loss of exclusive use of the line by virtue of granting to * * * a non-exclusive leasehold interest, in perpetuity, in the designated portion of taxpayer's track, subject to an obligation imposed on * * * to pay rental fees (including but not limited to its proportionate share of operation and maintenance costs).
The involuntary relationship between the taxpayer and * * * has characteristics present in both easements and leaseholds. In * * * G.C.M. 35491, I-5082 (September 24, 1973), the similarities between these two types of property interests [FN5] are acknowledged.
An easement is a nonpossessory interest that allows the owner of the property to continue to use the property for his or her purposes, subject to those limitations necessary to avoid infringement of the grant of rights contained in the easement.
The Restatement, Property (1944), in defining an provides that:
An easement consists in a privilege on the part of the person entitled to it to make some use of land subject to it. It must, in some way, limit the use of the property which the possessor of the subject land might otherwise make. It must, in addition to this, be in itself a property right, a right protected not merely against the possessor of the land subject to it but also against others. It must consist of such privileges of use as taken collectively are by accustomed habit deemed capable of creation by conveyance and must have the quality of being incapable of termination at the will of the possessor of the land subject to it. Id. section 8.5 at 232.
The joint-use agreement in this case manifests these characteristics. It consists of a privilege on the part of * * * to make use of the track belonging to the taxpayer. It likewise limits the use that the taxpayer can make of that track. The right granted to * * * is in perpetuity and thus protected againt infringement by the taxpayer, as well as by others. Furthermore, the agreement grants a non-exclusive right of use of a type that can be created by conveyance and it cannot be terminated at the will of the taxpayer.
In duration, the present arrangement is distinguishable from typical possessory interests created by leases, the characteristics of which generally include exclusive possession by the lessee, enforceable against the lessor, for a defined period (usually a term of years). See Nay v. Commissioner 19 T.C. 114, 119 (1952); Wineberg v. Commissioner, T.C.M. 1961-336, aff'd 326 F.2d 157 (9th Cir. 1963); TCR 15, 892, GCM 38046, I-477-78 (August 13, 1979). The agreement in the present case is not for a defined period, but rather for perpetual, intermittent use of the taxpayer's track. The agreement creates a permanent restriction on the taxpayer's use of its track; the taxpayer cannot sell or abandon the track without permission of DWP, which then has a first refusal right of purchase. We do not find that the present arrangement ceases to be an easement simply because the * * * will pay a fee of * * * per car using the line, as its share of maintenance costs.
Based on the factors considered in the foregoing discussion, the present situation should be treated as the involuntary creation of an easement, analogous to the situation discussed in Rev. Rul. 72-433, 1972-2 C.B. 470, considered in * * *, G.C.M. 34661, I-4104 (November 1, 1971 and May 11, 1972).
The Board of Tax appeals in Piedmont Mt. Airy-Guano Co., 3 B.T.A. 1009 (1926), acq., V-2 C.B. 3, (1926), acq. withdrawn, nonacq. substituted, x-1 C.B. 89 (1931), nonacq. withdrawn, acq. substituted, 1942-2 C.B. 15, held that the right to use and occupy a particular premises is a property right. The Piedmont court determined that use and occupancy is a property right inherent in the ownership of physical property and when such property is destroyed by fire, the portion of use and occupancy insurance that is immediately used in replacing such property in a condition fit for use and occupancy may be excluded from gain under section 234(a)(14) of the 1929 Revenue Act (now section 1033(a)). The decision and the acquiescence in Piedmont thus imply that section 1033 may be applicable when there is deprivation of use.
A subsequent revenue ruling, Rev. Rul. 38, 1953-1 C.B. 16, considered by this office in * * *, A-479865 (November 25, 1952), seemed to reach a conflicting result. The revenue ruling held that condemnation proceedings employed in the United States Government's acquisition of the use of a taxpayer's warehouse for a term of five years did not result in recognition of the compensation paid to the taxpayer as a gain from the involuntary conversion of property deferrable under section 112(f) of the 1939 Code (now section 1033). The ruling states that the taxpayer disposed of no property and that the compensation constitutes rental remuneration for use pursuant to the leasehold interest in the property acquired by the government. This result and the inherent conflict with Piedmont Mt. Airy-Guano Company, supra., were reconsidered by our office in G.C.M. 35767, * * * I-369-73 (April 4, 1974), and we recommended that Rev. Rul. 38 be modified to reflect a position that the lease granted to the United States Government is property for purposes of section 1033.
Arguably, a modification of Rev. Rul. 38 was effectuated in Revenue Ruling 72-433, 1972-2 C.B. 470, considered in G.C.M. 34661, * * *, I-4104 (November 1, 1971 and May 11, 1972).There, it is held that to the extent that the proceeds of an award resulting from the involuntary grant of an easement of flowage with some beneficial use of the land retained by taxpayer are invested to replace the property involuntariy converted (that is, to restore the volume of production to its former level), the taxpayers may utilize the provisions of section 1033 to defer the recognition of gain. The property subject to the easement was farmland. As a result of the flowage easement, use was restricted in two respects. First, the taxpayer could never build on the land and second, it was anticipated that farming activity would be hampered or prevented by flood waters once every 6 years.
In holding that section 1033 was applicable, G.C.M. 34661 notes that the grant of an easement that deprives the grantor of virtually all beneficial use of the servient parcel, leaving the taxpayer with mere legal title, is tantamount to a sale of the servient parcel. Scales v. Commissioner, 10 B.T.A. 1024, acq. 1, VII-2 C.B. 35 (1928). See also Rev. Rul. 54-575, 1954-2 C.B. 145, considered in * * *, A-610536 (April 15, 1954) (recognition of gain may be deferred under section 1033 when grant of an air-rights easement under threat of condemnation renders portions of farm virtually unusable); Rev. Rul. 56-436, 1956-2 C.B. 520, considered in G.C.M. 29400, * * *, A-617181 (April 5, 1956) (section 1033 deferral applicable to damages when flooding by a dam project with a surface easement caused the destruction in whole or in part of the taxpayer's retained mineral estates); G.C.M. 33777, Right-of-Way Easement Grants, I-2921 (March 25, 1968) (stating generally that Rev. Rul. 54-575 and Scales provide that if the grant of an easement deprives the taxpayer of practically all the beneficial interest in his land except for the retention of mere legal title, the transaction is considered to be a sale of the land covered by the easements).
Both Rev. Rul. 72-433 and the underlying G.C.M. draw an analogy, for purposes of section 1033, between condemnation awards paid for easements and severance damages that are paid with respect to retained property. [FN6] Noting that both types of payment reimburse the owner for a diminution in the value of land to which he retains title, the G.C.M. concludes that the treatment of the reimbursement proceeds ought to be the same for tax purposes. Both the revenue ruling and the G.C.M. cite, for support, Rev. Rul. 69-240, 1969-1 C.B. 199, in which the taxpayer was permitted to defer recognition of gain under section 1033 for both the condemnation award and severance damages received when the taxpayer's farm was bisected by a highway. In light of this and the perceived similarity in purpose and effect of proceeds from easements and severance damages, the G.C.M. concludes, and Rev. Rul. 72-433 holds, that Rev. Rul. 54-575 is incorrect to the extent that it limits applicability of section 1033 to situations in which a taxpayer is deprived of 'practically all the beneficial interest' of property subject to an involuntarily granted easement.
The extent to which the grant of a perpetual flowage easement deprived the taxpayer in Rev. Rul. 72-433 of his beneficial rights in the land is not readily apparent from the facts. It is possible on the facts that the land was rendered substantially less valuable as farmland due to the periodic flooding and resultant changes in soil quality and prohibition against any facility for human habitation. If the facts of Rev. Rul. 72-433 are so interpreted, it may be contended that while the revenue ruling modifies Rev. Rul. 54-575, supra, to the extent that it holds the application of section 1033 is limited to a situation in which the taxpayer is deprived of practically all his beneficial rights in property, it does so only to a limited extent and still requires a substantial loss of availability or of beneficial use or rights before section 1033 is applicable.
We believe that this restrictive interpretation of the revenue ruling is inappropriate. Section 1033 has been interpreted as a relief provision and as such should be construed liberally to give effect to congressional intent. Paul Haberland, 25 B.T.A. 1370, 1378 (1932); Washington Markets Co., 25 B.T.A. 576, 584 (1932); John Richard Corp. v. Commissioner, 46 T.C. 41, 44 (1966); S & B Realty Co. v. Commissioner, 54 T.C. 863, 870 (1970) acq., 1970-2 C.B. XXI. Neither the statutory language nor the accompanying regulations compel a result that restricts the applicability of section 1033 to taxpayers whose property rights have been substantially diminished by involuntary conversion. Furthermore, so restrictive an interpretation is not supported by the purpose of section 1033.
The purpose of section 1033 was to allow taxpayers who have lost property under certain circumstances outside their control to invest the proceeds therefrom, undiminished by tax on the gain, in qualified replacement property, thus restoring themselves, in so far as possible, to their position prior to the involuntary conversion. In S. H. Kress and Co. v. Commissioner, 40 T.C. 142, 153 (1963), the Tax Court stated that the basic purpose of section 1033 is to allow the taxpayer to replace his property without realization of gain 'where he is compelled to give up such property because of circumstances beyond his control.' See also S. E. Ponticos Inc. v. Commissioner, 40 T.C. 60, 64 (1963). In C. G. Willis, Inc. v. Commissioner, 41 T.C. 468, 476 (1964), the Tax Court stated that 'Involuntary conversation within the meaning of section 1033(a) means that the taxpayer's property, through some outside force or agency beyond his control, is no longer useful or available to him for his purposes.'
In the present case, it appears from the facts, that if the state were to force the taxpayer to permit * * * to use the present track without modification, the track would, in all probability, soon be rendered unavailable and useless. Furthermore, the taxpayer has asserted in its supplemental submission, dated * * * that the State of * * * has acknowledged that the re-routing of * * * traffic over taxpayer's right-of-way has diminished the usefulness of taxpayer's remaining facilities. These harms seem to be primarily the loss of flexibility, possible delays in traffic flow and potential maintenance and managerial costs. The taxpayer has also stated that the resultant restrictions on its free use of track and on the ways in which it could alter its track and service in the future may damage its ability to compete for business.
The present case is analogous to the payment of severance damages on the same theory as the flowage easement situation discussed in G.C.M .34661 (Supp.) supra. In each case, the taxpayer has experienced an involuntary conversion of a property interest in land to which he retains title. In each, he is compensated with an amount determined on the basis of anticipated damages flowing from the diminution in the usefulness of the property to him. In the present case, the evidence presented indicates that use of taxpayer's track by * * * without the required improvements would impair and perhaps destroy the usefulness of the track to the taxpayer, who would then be obliged to repair or rebuild the track to restore its usefulness to him. This anticipated repair and restoration expenditure is essentially what the state is paying the taxpayer as damages through the mechanism of modifying the track now.
As discussed, treating the condemnation proceeds in a manner analogous to the payment of severance damages and determining that section 1033 is applicable, is consistent with both the purpose of section 1033 and the position set forth in Rev. Rul. 72-433.
C. Reinvestment Requirement
Availability of section 1033(a) deferral of recognition of gain is conditioned on reinvestment of the gain in replacement property that is similar or related in service or use to the property converted. Section 1033(a)(2)(A). The Service has historically applied a 'functional use' test in defining this requirement. The test holds that property is similar or related in service or use if the physical characteristics and end uses of the converted and replacement properties are closely similar. This 'functional use' test, as applied to owner-users of property, was affirmed in Rev. Rul. 64-237, 1964-2 C.B. 319.
The reinvestment standard is essentially the same with respect to severance damages otherwise qualifying under section 1033(a). Here the reinvestment must restore the usability of the retained property in order to qualify for deferral within the mandates of the 'similar or related in service or use ' test. Thus, restoration of usability need not be to the exact same use but must be to a similar or related use. G.C.M. 38256, * * *, supra.
In the subject case, the taxpayer operated the track as it existed prior to the condemnation. He will continue to operate the track after the involuntary improvements are made. The replacement property is similar or related in service or use. [FN8] The fact that as a result of the forced easement for joint use heavier, more sophisticated and perhaps more valuable track is required to restore the taxpayer to its prior level of use does not cause the reinvestment to fail the similar or related in use test. The improvements will merely permit taxpayer to continue to use the track as it had done before the forced grant of a permanent easement for use by * * *.
GEORGE H. JELLY
BRUCE Z. SEGAL
Technical Assistant to the Director
This document is not to be relied upon or otherwise cited as precedent by taxpayers.
END OF DOCUMENT