There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Sometimes bad things happen, and when they do, the last thing people want to worry about is the tax implications. This is the third in a three part series that I've been building up to. Uh, on what? I just kind of, uh, sum [00:00:30] up as the tax implications of when bad things happen. The first episode in this series was on Casualty Losses. What happens, uh, when stuff is destroyed or damaged beyond repair? The second episode, uh, in this series, was on theft losses. What happens when somebody steals our stuff? How does that affect our taxes? This episode, uh, is going to be a little bit different because we're going to talk about the aftermath of those situations. [00:01:00] What happens when we replace those items? This episode is on what's called involuntary conversions. As I've discussed in those previous episodes, there are tax provisions that can help alleviate some of the pain and suffering of those casualty losses or theft losses. But when we actually need to replace that property, there's another set of tax rules that come into play as well. And in particular, they [00:01:30] affect how we think about our basis in the new property. We're going to talk about involuntary conversions under IRC section 1033. That's the section that covers all of the rules, along with the regulations for that section on how involuntary conversions work. You might notice that that's pretty close to IRC section 1031, which is on like kind exchanges. There's actually some Some similarity between those two principles. [00:02:00]
Jeremy Wells: And I did another episode on 1031 exchanges, like kind exchanges. But 1033 is a different set of rules for a different set of circumstances. A like kind exchange is when we're going in and we're just exchanging one kind of business property for another. And since the Tax Cuts and Jobs Act, that's been limited down to only talking about real property. So usually we're talking about rental properties. Here was section 1033. It's actually much [00:02:30] broader scope of what can be replaced under an involuntary conversion. Real estate and real property is still part of it, but it can actually apply to personal property as well. So whether you lose a house in a fire or you have land taken by eminent domain or you own property destroyed in a natural disaster, section 1033 can offer tax relief by allowing either a nonrecognition of the gain on the sale of the converted [00:03:00] property and then the replacement property, or in some circumstances, there might be a deferral of gain when that replacement property is purchased. I'll walk through how these involuntary conversions work, what qualifies for this treatment, and then what traps to avoid when we're advising clients through some of life's most disruptive events. In this episode, we're going to look at what an involuntary conversion actually is, what the definition of it is, and what kinds of situations qualify [00:03:30] as an involuntary conversion. We're going to look at the criteria for successful nonrecognition of gain following an involuntary conversion.
Jeremy Wells: That's our ideal situation from a tax perspective when we have a complete nonrecognition of gain. However, there are some circumstances where we can still benefit even if we don't meet those criteria. And so we'll look at the available election to defer recognition of gain in certain circumstances under these involuntary conversion rules. We'll also look at how to calculate [00:04:00] the basis of the replacement property following an involuntary conversion. Before we get started, I want to go back to a case study that I used to frame the casualty loss episode. In that episode, I talked about Jessica owning a small print shop in North Florida, and she was operating that print shop out of a commercial building that she owned for over a decade. She [00:04:30] reports that activity on a schedule C, and in late 2023, a hurricane caused extensive damage to both the building and her printing equipment. Her property insurance covered the building only. The building's basis was $200,000, with a fair market value of $400,000, but insurance paid out $250,000. Now, in that episode, I said that she considered the building a total loss. She paid for minimal cleanup and repairs, [00:05:00] and she decided to lease another property instead. What I want to do in this episode is think about if Jessica could have handled this situation a little bit differently. If you haven't listened to that episode on Casualty Losses, you might want to pause and go back and listen to that.
Jeremy Wells: In fact, in that episode, I concluded by showing how she actually had about $50,000 of gain of recognized gain from the way she handled that, uh, that casualty loss [00:05:30] with her, uh, with the building. In this episode, I want to talk about how she might have handled that a little bit differently from a tax perspective. So let's get into what an involuntary conversion is in order to qualify for gain non-recognition or deferral under IRC 1033, the conversion has to be either compulsory or involuntary. These are the two terms that show up either in the regulations or in the case law [00:06:00] around involuntary conversions. A conversion of property is compulsory or involuntary if the taxpayer's property, through some outside force or agency beyond her control, is no longer useful or available to her for her purposes. There's going to be a set of situations where this can happen automatically. Casualties and thefts qualify. [00:06:30] Casualties and thefts are situations that are outside the taxpayer's control. The taxpayer no longer has use or availability for her purposes of that property. If someone steals your property or if your property is destroyed in a natural disaster, for example, then that situation generally is going to automatically qualify for involuntary conversion treatment. It's going to meet the [00:07:00] definition. There's another set of situations, though that are included here as well, that I'll talk about in a minute. And that is where the government, through various, uh, processes, can actually take individual property for the greater good.
Jeremy Wells: This is what's going to be called either a condemnation or a seizure of property. Now there's a limitation here, though that comes up in the case law. This [00:07:30] actually comes from a tax court case, Willis v Commissioner from 1964. If the property could have been reasonably repaired or restored to working condition, but the owner chose to sell instead, then the conversion was not involuntary. This is an interesting court case that actually deals with a company that ran transport ships up and down the Atlantic coast of the US. One of the ships ran aground and the company [00:08:00] after a while got some bids to repair it, decided they didn't want to go through that, ended up selling it, instead bought a replacement ship and tried to treat this as an involuntary conversion. Tax court actually agreed with the IRS and said, you got some bids to repair the boat. You could have repaired it. You just chose not to. That doesn't qualify as that ship no longer being useful or available for use. It just needed some repairs. [00:08:30] So that's a limitation to keep in mind that if the property could be repaired and restored under normal sort of repair or restoration conditions, then it's generally not going to qualify as an involuntary conversion. If it's been damaged beyond repair or completely destroyed, then it's typically going to qualify for this treatment.
Jeremy Wells: Now. Again, generally a casualty theft, requisition, condemnation or seizure is [00:09:00] going to qualify for non recognition under IRC section 1033. And the prior two episodes I talked about casualty and theft losses. Those are covered under IRC section 165. Generally, anything that's going to qualify under that code section is also going to qualify for an involuntary conversion under section 1033. Now there are a couple terms I added here though to casualty and thefts, requisition, condemnation or seizure through [00:09:30] some case law and through some IRS guidance, we actually get an idea of what we mean by these extra terms. A seizure occurs when a government agency takes property against the will of the owner for public use in a requisition or condemnation. The government authority takes the property against the will of the owner for public use, but compensates the owner according to a judicial order. Usually what will happen is you have a [00:10:00] local government, uh, usually either a city or maybe a county, or in some cases it will actually be the federal government, usually through some legislative process. But in either case, there will usually be some judicial backing, uh, some authorization for this, uh, requisition or condemnation of property. And the government will notify the taxpayer that this property is going to be requisitioned [00:10:30] or condemned, and there will usually be some offer of monetary compensation to the taxpayer. That's usually within a certain, uh, interval of fair market value. It may not be what the taxpayer could actually get on the market.
Jeremy Wells: And we'll talk about some situations where taxpayers might decide to sell to a third party under the threat of a condemnation or a requisition [00:11:00] or requisition. But in those cases where the government is going to claim that property for public use, this can be, uh, buying land or buildings in order to build a highway or to, uh, just, uh, take out a section of a city that is suffering to blight. It's suffering due to blight, uh, or just a lack of, uh, activity in that area. And maybe the city wants [00:11:30] to come in and redevelop that and make it, uh, more useful to the city's population. In those situations, the taxpayers might be offered some compensation. However, they really don't have a choice in the matter. Uh, that property is going to be taken by that government agency or that government unit, regardless of, uh, you know, any sort of fight that they put up in those cases where it's going to qualify for involuntary conversion. That definition, by the way, of, [00:12:00] uh, requisition or condemnation that comes from an IRS revenue ruling, 79 269 and also even a threat or imminent, uh, condemnation or requisition can qualify for an involuntary conversion. That actual condemnation or requisition requisition doesn't have to actually have already occurred. So a threat or imminent of condemnation exists when a property owner is [00:12:30] told either directly by a government official or through confirmed news reports, that the government has decided to acquire the property for public use, and the owner reasonably believes condemnation will follow if a voluntary sale doesn't occur, that comes from revenue ruling 63 221.
Jeremy Wells: So it's entirely possible for a taxpayer to just hear, uh, substantial, significant reports of an oncoming condemnation and from that, [00:13:00] decide to sell the property either to, uh, a government agency once that offer comes in or to a third party. And in that case, that's still going to qualify as an involuntary conversion. However, if an individual representing a condemning agency does not identify the agency to the taxpayer, then the taxpayer lacks reasonable grounds to believe that threat or the imminence of condemnation [00:13:30] and the sale of that property does not qualify for non-recognition. This comes from revenue ruling 74 eight. So the there's a caveat here. In order for that threat to be credible, the taxpayer has to know precisely where that threat is coming from. So it can't just be the taxpayer hearing some rumors or innuendo or some unverified reports, and assuming that this threatened condemnation is going to happen and then sell the property, the taxpayer has [00:14:00] to actually be able to point to a specific agency and be able to credibly claim that, uh, she believes that that condemnation is actually happening. If the taxpayer sells the property to a third party under the threat of condemnation, then that can qualify as an involuntary conversion.
Jeremy Wells: There's an interesting pair of revenue rulings, 81 180 and 81, 181, [00:14:30] where the taxpayer sold the property to a third party after reading a news account quoting a city official saying that the city would condemn his property if a sale couldn't be negotiated. In that case, the taxpayer reasonably saw this as a threat of condemnation, but then sold the property to a third party. That's from revenue ruling 81 180. And in that revenue ruling, the IRS determined that that [00:15:00] did in fact qualify as an involuntary conversion, that that taxpayer sold that property under a bona fide threat of condemnation. So even though it was sold to a third party and not the government agency that was threatening, the condemnation is still qualified as an involuntary conversion. There's also some case law that supports this. Uh, there is an appellate court ruling in Creative Solutions v us. Uh, that was in the Fifth [00:15:30] Circuit in 1963, then in revenue ruling 81 181. We get what, the third party. So we get the conclusion of this story. We get what the third party did in this situation, and the third party was the one that ended up selling to the government agency. But before that, the IRS asked whether the actual purchase of property that [00:16:00] was known to be under threat of condemnation would qualify for an involuntary conversion. In other words, if I purchase a piece of property that I know is going to be requisitioned or condemned, can I then still qualify for an involuntary conversion? Right.
Jeremy Wells: I knew that was going to happen. Therefore, does it really qualify as an involuntary conversion? And in this revenue ruling, the IRS decided that yes, it does. The taxpayer purchased that land under a known threat of condemnation, [00:16:30] that that purchaser knew that the condemnation was going to happen. Uh, and then later sold the property to the government authority that sale qualified as an involuntary conversion, and the IRS actually determined that IRC 1033 does not require that a taxpayer acquire property free from any threat of condemnation, or without any knowledge of an imminent condemnation, that even if you know that there is a condemnation [00:17:00] happening, you're aware of the threat, you're aware of its imminence, then it still qualifies as an involuntary conversion. Now, the sale of the converted property is half of the transaction here. In terms of section 1033, the other issue here is we're converting that former property into some replacement property. And there are some rules about the replacement property as well. There are two ways that you [00:17:30] can convert that property into replacement property. Either the replacement property is similar or Related in service or use to the original property to the to the converted property, or it's not. In the first case where we have that the original property is converted into property that's similar or related in service and use, then we have what we call non-recognition treatment.
Jeremy Wells: This is under section 1030 3A1. [00:18:00] Mandatory non-recognition treatment is the way this is described. So whether the replacement property is similar to the converted property, it's going to depend on an analysis of those two different properties. And that's going to depend on looking at how the taxpayer uses those two properties. But in general, if we can claim that the taxpayer's use or, uh, reason for owning that, uh, replacement [00:18:30] property is similar or the same as the original property, then we automatically have non-recognition of any sort of gain in that conversion similarity. What does this actually mean? Well, it depends on whether the taxpayer, uh, uses the original and replacement property or whether the taxpayer just merely owns those properties. In other words, is that investment property? [00:19:00] If the taxpayer actually uses the property, they're similar if the taxpayer functionally uses them. Similarly, there's actually a pretty significant amount of case law that looks at situations where the taxpayer had the original property involuntarily converted into a replacement property, and then the IRS, uh, would reject the claim of non-recognition due to an [00:19:30] involuntary conversion, because the IRS thought that the use of the replacement property wasn't similar enough to the taxpayers use of the original property. In some of those cases, the taxpayer won because the use was similar enough, according to the court. In some of those cases, the IRS won because the use was dissimilar enough. However, there's a string of cases where the courts pretty much [00:20:00] agreed, and these cases often came through the Tax Court first and then found their way into appellate courts, where both the IRS and Tax Court agreed that the use of the original property and the replacement property were different.
Jeremy Wells: But the taxpayer, from the taxpayer's perspective, was an investor. The taxpayer just owned the property and then leased it out, and the tenants determined how the property was actually used. [00:20:30] For example, if an owner owns a piece of commercial property and a tenant uses it as warehouse space, and then for some reason, the owner of that property, uh, involuntarily converts into a replacement property. And now that replacement property is instead an apartment building instead of a commercial warehouse. From the taxpayer's perspective, it's still rental property. Now, it might have changed from commercial [00:21:00] to residential, but it's still rental property. The taxpayer is still looking at that as investment property. According to the IRS and the Tax Court's functional use approach, though, those are two different kinds of uses of those property. In one case, it's commercial warehouse, in another case, it's an apartment building. So the IRS rejected the claim of an involuntary conversion and the non-recognition of the gain. And the tax court agreed in a few of these cases. However, [00:21:30] in those cases, when the taxpayer appealed to an appellate court, the appellate court, and this is over several different circuits in the US judicial system.
Jeremy Wells: The appellate courts would find that it really is the same use from the taxpayers perspective. It's still investment property and the investor, the owner can't control how the tenant use that property. So whether the investor owns commercial property [00:22:00] and that property, uh, was a warehouse and now the replacement property is instead a floral shop, that's not really up to the investor. That's up to the tenants how they want to use that property. And this, uh, really occurred during the 1960s. We see several cases in the appellate courts where those courts reversed decisions made by the IRS and the Tax Court, where the IRS and Tax Court agreed that the replacement property wasn't similarly used enough to [00:22:30] the original property, but the appellate court said that from the taxpayers perspective, they really were. And even this wasn't throwing out the tax court's functional use test. It was just saying that in cases where the taxpayer is an investor, as an owner of a rental property, that the functional use test really doesn't apply, and we definitely can't apply it at the level of the tenant. We have to apply at the level of the taxpayer. And from the taxpayer's perspective, the functional use is pretty much [00:23:00] similar that lent record versus commissioner. This was in the Second circuit in 1962 and then Loco Realty v Commissioner. This made it into the Eighth Circuit Appellate Court in 1962 also. And there's these two cases are representative. There are several others that are similar really in the late 50s, early 60s.
Jeremy Wells: We get a lot of court activity over these involuntary conversion. It's kind of an interesting period to see how this [00:23:30] principle gets developed through some of these court cases, if the taxpayer converts property into a replacement property, that is either dissimilar in terms of its use by the taxpayer or into money in these cases, then it's no longer a question of not recognizing the gain. Rather, it's a question of deferring the gain. So a taxpayer generally has to recognize the full [00:24:00] amount of gain on a conversion if she receives cash, or if the replacement property is not similar or related in service to the converted property. But in section 1030 3A2, the taxpayer is allowed to elect to defer the gain if within a specified replacement period, she acquires property similar or related in service or use to the converted [00:24:30] property. There's also another option where the taxpayer can instead acquire stock that gives the taxpayer a controlling interest in a corporation at least 80% control of that corporation that owns property similar or related in service or use to the converted property. So in other words, there's an out here where instead of just directly purchasing the property, that taxpayer can actually purchase a controlling interest in a corporation that owns [00:25:00] property of a similar use. I'm not exactly sure, uh, when or why this would happen, but it's there, uh, just in case.
Jeremy Wells: And so that election is important to keep in mind. In a lot of cases, especially in the modern economy, the, uh, individual taxpayer is not going to directly Replace one kind of property with another. Instead, what's [00:25:30] going to happen is that taxpayer is going to get some kind of compensation. Either that's going to be compensation coming from a government authority that is condemning property, or it's going to come from an insurance payout. In those cases, the replacement property in the meantime is cash for that taxpayer. And here in these cases, the taxpayer has a choice. The taxpayer can keep the cash. And in that case, [00:26:00] there is not going to be any sort of non-recognition of that gain. That gain is going to have to be recognized when the taxpayer receives that insurance payout or that payout from the condemning government agency. However, the taxpayer can elect to purchase replacement property Within a specified replacement period. Now, that period [00:26:30] generally begins on the earlier of the date of the disposition of the converted property, or the earliest date of the threat or imminence of requisition or condemnation of the converted property. So generally we're going to look at, in the case of a casualty or a theft, it's going to be the date of that casualty or theft. That's going to be the date that the replacement property period starts. Or if instead the conversion is due to [00:27:00] a threat or imminence of requisition or condemnation, then it's going to be the date that the taxpayer finds out about that threat.
Jeremy Wells: So we're going to go to that date. Then we're going to go to the end of that tax year. And then two years generally from the end of that tax year is the end of that replacement period. So we have two years plus the time to [00:27:30] the end of the year. So generally we look at a two year replacement period when the taxpayer receives cash, uh, in lieu of, uh, a replacement property for the converted property that is specifically in section 1033 A to capital B, there are some situations where Congress has allowed a bit of extra time. This is in 1033 G [00:28:00] and then H. So if we're looking at real property used in a trade or business converted into like kind property due to seizure, requisition, condemnation or the threat thereof. So we're looking at real property used in a trade or business. Then in this case it's three years. So we have three years from the end of the year of that condemnation or requisition for the taxpayer to identify and purchase the replacement property. [00:28:30] If it's a personal principal residence, then it's a four year period. If that residence is converted into insurance proceeds due to a federally declared disaster, and I'm going to come back to involuntary conversions with a principal residence because there are a couple of other rules we need to look at.
Jeremy Wells: We especially need to look at the interaction with section 121. But [00:29:00] for a principal residence, that period is actually four years. If the conversion is due to a federally declared disaster, and then there are some specific situations where in legislation that wasn't part of tax law, it's not in the tax code, but in some specific legislation. Congress designated a five year replacement period for some disaster areas, including the Midwestern floods in 2008, Hurricane [00:29:30] Katrina in 2005, and then the September 11th, 2001 terrorist attacks in New York City. So there are some specific situations where Congress might identify a longer time period for that, for finding that replacement period. Um, in those three situations, it was it was five years instead of two years. And it is possible to request up to a one year extension generally, uh, from IRS. Now, it's [00:30:00] not a hard and fast limitation of one year. But in general, according to the IRS, it's an up to one year, uh, extension of the specified replacement period, usually up to one year. The taxpayer can make the request before the end of the replacement period and provide a reasonable cause explanation for the extension, usually such as unfinished construction of the replacement property. That's a pretty typical reason [00:30:30] for getting that extension. Now, there are some situations where the IRS pretty flatly will not allow for an extension, and that's where either due to high market values or a scarcity of replacement property, the the taxpayer claims that she just can't find a replacement property or she can't find a reasonably priced replacement property.
Jeremy Wells: And in those cases, the IRS generally won't accept an extension request. The IRS has on their website [00:31:00] the instructions on how to request that extension. There's essentially a cover letter that needs to have some identifying taxpayer information. And then the request itself where the taxpayer explains the situation, the converted property, the attempt to find replacement property and give that reasonable cause explanation for needing extra time. This all comes from Treasury Regulation Section 1.1 33, a [00:31:30] hyphen, two C3, as well as a couple revenue ruling 60, 69 and 76 540. So in those revenue rulings and in that regulation, we get these rules for these extensions. It's up to one year. It might make the difference between that taxpayer being able to actually find the replacement property or not, but it is a limited extension to that period. Like I said, when it comes to [00:32:00] replacing a principal residence in an involuntary conversion, we actually first have to look at section 121 and how that applies to a principal residence. Uh, first, I've got a prior episode on section 121 and how that affects a taxpayer's situation when she sells her principal residence. I recommend going back and listening to that episode [00:32:30] if you haven't already. But if a taxpayer realizes a gain from an involuntary conversion of a principal residence as defined in section 121, then she first applies section 121 and treats that conversion as a sale or exchange, and therefore excludes up to $250,000 or $500,000 of married filing jointly of the gain from that home.
Jeremy Wells: So apply section 121 [00:33:00] first when the converted property is the taxpayer's principal residence. And like I said, I definitely recommend going back and listening to episode nine on Selling Principal Residence if you haven't listened to that episode yet. If there is any gain from the conversion of the principal residence in excess of the amount that can be excluded under section 121. Then the taxpayer can defer the excess gain by [00:33:30] purchasing a qualifying replacement property, and in this case, the ownership and use periods also tack to the new residence. So if a taxpayer lives in a principal residence, lives in and owns it for, uh, let's say one year, and because it's only one year, their section 121 doesn't apply. In that [00:34:00] case, if the principal residence is converted into another principal residence due to an involuntary conversion, then that taxpayer would defer the gain from the conversion of the original residence into the new one and also carry over the ownership and use period so that one year. Would apply to the replacement property as well. And so that's a way to help homeowners if they're in a situation where they have to involuntarily [00:34:30] convert their principal residence into a new home. But it's important to keep in mind that we first apply the section 121 exclusion before we can use section 1033 to defer any gain.
Jeremy Wells: And like I said before, that replacement period is extended generally for principal residences that have been involuntarily converted due to a natural, uh, due to a federally declared disaster. [00:35:00] There's also a provision here for what the code section refers to as separately stated scheduled contents. And this is essentially where, uh, some specific items inside the home have been itemized and listed out on, uh, by the insurance provider in the insurance policy. So if there are specific items that the homeowner lost as well due to this disaster, then the [00:35:30] insurance proceeds covering those separately stated scheduled contents, uh, that can also be used in this as well. So it's also going to be covered under section 121 and then section 1033, uh, if necessary. And again, that replacement period is four years, not just two years after the end of the first tax year, in which any part of the gain on the involuntary conversion is realized. So basically, the year when those insurance proceeds [00:36:00] are received by the taxpayer, that's IRC section. 1033 H. Generally, when we're looking at replacement property that has to be acquired from an unrelated person to the taxpayer, the taxpayer has to recognize gain on any involuntary conversion if she acquires the replacement property from a related person. What do we mean by a related person? That's going to be the same thing as defined [00:36:30] in section 267 B, which deals with personal relationships.
Jeremy Wells: So familial relationships like parents or children, aunts, uncles, brothers, sisters, um, but then also section 707 B1, which is looking at partners and partnerships. So if due to an involuntary conversion, a taxpayer purchases replacement property, but purchase it from someone that she's related to under section [00:37:00] 267 B or from a partner or a partnership under section 707 B1, in those cases, that taxpayer is going to have to recognize the gain. There's no way to apply the involuntary conversion rules in that situation. The limitation does not apply if the related person acquired the replacement property from an unrelated person during the replacement period. [00:37:30] So think about a situation where the related party purchased a piece of property, but it was within the taxpayer's replacement period within that generally two year period. Or maybe it's four years if it was a principal residence, as long as the related party purchased that replacement property within the taxpayer's replacement period, then it might still qualify. Uh, even though that would be a purchase from, uh, from the [00:38:00] related party by the taxpayer. That's kind of a weird situation. I'm not exactly sure how or when or why that would happen, but if that's the case, if you can make that connection that the, uh, that the related party made that purchase during the taxpayers replacement period, then that is a way to still be able to defer the gain under an involuntary conversion.
Jeremy Wells: And this limitation applies to C corporations, [00:38:30] partnerships, more than 50% owned by C corporations and any other taxpayer. If the aggregate amount of the realized gain on the property on which uh realized gain exceeds $100,000. So again, this is another out for this, uh, provision. If the realized gain is less than $100,000 than this, uh, doesn't necessarily apply, this limitation doesn't apply. However, uh, if that realized [00:39:00] gain exceeds $100,000, then you're going to need to look at whether this limitation applies or not. And this is all coming from section 1033 I. Now, what is the taxpayer's basis in the replacement property? The basis of replacement property is generally the same as that of the involuntarily converted property. So the basis is just going to carry over. And this is what we mean by the nonrecognition of gain. If [00:39:30] I have a certain amount of basis in a piece of property, that piece of property is involuntarily converted due to natural disaster or theft or some sort of condemnation by a government agency, then I go and I have a replacement property. I find and purchase a replacement property. My basis in the original property is going to carry over and be my basis in the replacement property. However, [00:40:00] if the taxpayer receives any money along with that replacement property, then she has to decrease her basis in the replacement property by the amount of money received.
Jeremy Wells: Unless you use that money to acquire the replacement property and there might be a gain recognition due to receiving that money, unless that money was all spent on the new property, and if the taxpayer recognizes [00:40:30] any gain or loss, then she has to either increase if there's a gain or decrease if there's a loss, her basis in the replacement property by the amount of that gain or loss. So this is normal tax accounting here, where if we do have to recognize some sort of gain or loss, we're going to adjust the basis of the replacement property by the amount of that recognized gain or loss. Now if you listen to the episode on 1031 exchanges, or if you know [00:41:00] about 1031 exchanges, then this should all sound familiar. This is similar, somewhat similar to the boot rules for like kind exchanges. We basically have a similar logic going on here with involuntary conversions. This is all from section 1033 B1. There's actually a few paragraphs within 1033 B1 that break down, uh, how this all works. But it's important to keep in mind that we have to pay attention not just to the converted property, but also the [00:41:30] replacement property. And if there's any money that changes hands in between, uh, there as well. Uh, if that money is coming to the taxpayer, that's the situation. If we have a nonrecognition of gain, what if we have deferred gain? The basis of the replacement property is going to be equal to the cost of the property reduced by the deferred gain.
Jeremy Wells: If the taxpayer purchases more than one piece of replacement property, [00:42:00] then she allocates the basis in proportion to their respective costs. So let's look at an example of this. Try to break this down. Let's say Seth owns a rental property with an adjusted basis of $100,000. A storm destroys that property, and Seth receives insurance proceeds of $300,000. He has a realized gain, not recognized, but realized gain here of $200,000 on [00:42:30] that involuntary conversion. From Seth's perspective, we want to not recognize or defer as much of that gain as possible. He. But in this case, because he collected a payout from insurance, we're looking at a situation where he received money. And so in this case, it's not going to be an issue of nonrecognition. It's going to be an issue of gain deferral. He uses those proceeds to purchase another rental property for $250,000 [00:43:00] within the specified replacement period. So he followed the rules, and he used 250,000 of the 300,000 in insurance proceeds to purchase the replacement property. So in this case, he's going to recognize a gain of $50,000. He is now $50,000 better off than he was, and he elects to defer that $150,000. [00:43:30] That gain is now going to be deferred by reducing the basis of the rental property. So he purchased it for 250,000. However, he's going to defer that gain of 150,000, and therefore he's going to have a basis of only $100,000 in the replacement property.
Jeremy Wells: And notice that's the same basis that he had in the converted property. So in that case, [00:44:00] the deferred For gain is just going to make those two bases equal. So when he turns around and sells under normal conditions, let's say he turns around and sells the replacement property. He'll be calculating his gain on that sale from the basis of 100,000, not from the cost of 250,000. So he hasn't. Not he hasn't gotten around not having to recognize the gain. He's just deferred that gain into the [00:44:30] sale of the replacement property. So this is a short term or maybe medium term depending on how long he holds that replacement property. But but this is just deferring gain. This isn't eliminating uh, gain. There is not going to be any sort of step up or anything like that here. He's just going to be able to defer that gain until he disposes of that replacement property. I mentioned earlier that there's an option for taxpayers to purchase stock in a Operation, [00:45:00] a controlling share, or at least 80% of controlling shares in a corporation, and that corporation then owns replacement property that is similar in use or function to the converted property. If the taxpayer involuntarily converts property into stock and because of the rules I just discussed, has to reduce the stock's basis, then the [00:45:30] corporation actually also has to reduce its basis in its property according to specific rules and ordering principles that are given in section 1030 3B3.
Jeremy Wells: These rules are a bit complicated. They're a bit complex, especially to go through in a podcast format, really, and I don't see a lot of cases where this would actually happen in normal practice of a of a small to [00:46:00] medium accounting firm. However, if you run into a situation where the taxpayer takes the route of purchasing stock in a corporation that then owns the replacement property. In that case, you might have to look at whether not only the taxpayer's stock basis has to be reduced, but also therefore the corporation's basis and its assets has to be reduced. That's a really interesting connection. Uh, there we don't we don't [00:46:30] see that often where usually a corporation stock and its basis in its assets. We keep those two things separate in this situation with an involuntary conversion, because we're talking about that taxpayer having a controlling interest, at least 80% of the stock in that corporation. We do have to make that adjustment so that the corporation's basis in its assets and the taxpayer stock in that corporation are both reduced Used according to those rules and ordering [00:47:00] principles. In the code section, I want to add in something that is often left out of these discussions of federal tax law, and that's how state tax law might come into play here. Oftentimes when we're talking about especially with depreciation, states may or may not conform to federal tax law.
Jeremy Wells: A lot [00:47:30] of times when we're looking at states that have income tax systems, we talk about conformity, especially when it comes to depreciation, because in federal tax law, we have a variety of ways to depreciate or expense capital assets. We have uh, along with just normal depreciation under the modified Accelerated Cost Recovery System or Macrs. We also have section 168 K bonus depreciation. We have section 179 expensing. Different [00:48:00] states with income tax systems may or may not conform to the the use of those special expensing provisions especially bonus depreciation. Some states will add back bonus depreciation and then recalculate depreciation based on what that state will allow for depreciation. For example, when it comes to section 1033, most states will conform to that. However, you should [00:48:30] still look at whether your state does in fact conform to that nonrecognition or that deferral of gain. So in general, always review state law to ensure conformity with any federal tax provision, but especially with IRC section 1033. For example, Oregon requires a taxpayer Air, who purchases a replacement property outside of Oregon to [00:49:00] add back to federal taxable income the deferred gain upon the sale of the replacement property. So this won't affect the taxpayer when the taxpayer has the actual conversion into the replacement property, but it will affect the taxpayer when she goes and sells the replacement property. And added to that, in the meantime, in order to help the state track that, the Oregon Department of Revenue [00:49:30] may, uh, in terms of Oregon's uh, statutory law, the Department of Revenue may require taxpayers owning replacement property outside of Oregon to file an annual report on that replacement property.
Jeremy Wells: That's from Oregon Revised Statutes, Section three 16.7 38. Now, this is kind of a weird example. Oregon is still, for the most part, going to conform to section 1033 here. Uh, [00:50:00] unless the taxpayer purchases that property outside of the state of Oregon. And in that case, Oregon will have this ad back to federal taxable income of that deferred gain upon the sale of the replacement property. And Oregon might require that annual report. So, again, it's important to look at the individual state and see what exactly, uh, conforms to federal tax law [00:50:30] and what doesn't. There is no such annual reporting of a replacement property for federal tax purposes, whether we're talking about a section 1033 and voluntary conversion or a section 1031 like kind exchange, there's no annual reporting of that. But we do have that here in the case of, of Oregon. Or we may if the Department of Treasury or Department of Revenue, uh, requires that annual reporting. Like I [00:51:00] said at the beginning of the episode, I wanted to go back and look at Jessica's situation. So she decided to lease another property rather than purchase a replacement property for her shop. Was that a good move from a tax perspective? So her $250,000 insurance payout resulted in a $50,000 gain.
Jeremy Wells: Now, there was also a bit of gain or loss from the, uh, casualty with her equipment. But let's just focus on the building [00:51:30] for now. She received an insurance payout. So this is a case where she converted her, uh, commercial property into cash. So we're in a deferral of gain situation. We're not in a nonrecognition situation. We're in a deferral situation. Which means she could have elected to defer that gain. If she had used the insurance proceeds to purchase a replacement property so she could have taken [00:52:00] that $250,000, tried to find a commercial property, bought that, and then deferred that gain into that replacement property. Instead, she can keep that cash. She can lease a new property, but she's going to recognize that $50,000 of gain instead of replacing that property. So this is a situation where, as a tax advisor, we might want to talk to our client and walk them through the options they have. If they're [00:52:30] dealing with an involuntary conversion and make sure they understand that they might recognize some actual gain, or they might have an opportunity to defer that gain. There might be confusion about the fact that the taxpayer is receiving insurance proceeds because a lot of taxpayers are confused, oftentimes with the tax implications of how insurance proceeds are going to affect them. And [00:53:00] in the case of involuntary conversions, there might actually be some gain recognized from those insurance proceeds.
Jeremy Wells: They may not want to spend the money on purchasing a replacement property. On the other hand, they may not want to recognize any gain from that insurance payout. So it would be important in this kind of situation to walk them through the different options they have and how those options will affect their tax situation. If you're a taxpayer, you might want to look at that. If you get an insurance [00:53:30] payout due to either a casualty or a theft or one of these involuntary conversion situations, you might need to look at either reserving some of that insurance payout for an increased tax bill, or you might want to start the clock on that replacement period, because it's going to be two years from the end of the year when you receive that insurance payout to find a replacement property. This wraps up this three part series on casualty losses, [00:54:00] theft losses, and involuntary conversions. This general topic of the tax implications of when bad things happen is a really interesting set of situations. It's also really important and critical time where as tax advisors, we might really need to be there for our clients to make sure even though they don't want to deal with it, they need to understand the tax implications of what's going on in their life. So when disaster strikes, the last thing anybody wants to worry about [00:54:30] is these tax implications. But with a little knowledge, you can make sure that you or your clients get the best possible tax treatment.