What to Do With Condemnation Proceeds for Taxes

When a government entity exercises its power of eminent domain to take private property for public use, the owner receives a payment known as a condemnation award. The receipt of these funds is a taxable event, similar to a sale. The tax consequences depend on the amount of the proceeds, the property’s cost basis, and how the owner uses the money.

Calculating the Realized Gain or Loss

To determine the tax impact of a condemnation, you must first calculate the gain or loss realized from the transaction. The basic formula is the total proceeds received minus the adjusted basis of the property.

The proceeds are primarily the condemnation award paid for the property. This amount can be adjusted by other related payments. If you receive severance damages as compensation for a decrease in the value of your remaining property, these funds reduce the basis of that remaining portion. Conversely, if a special assessment is levied against your remaining property for public improvements, this amount may be subtracted from the total award, reducing your proceeds.

Your property’s adjusted basis is its original cost plus the value of any capital improvements, minus any depreciation you have claimed. For example, if you bought a commercial lot for $200,000, spent $50,000 on improvements, and claimed $20,000 in depreciation, your adjusted basis would be $230,000. If you received a condemnation award of $300,000, your realized gain would be $70,000.

Deferring Gain Under Involuntary Conversion Rules

Receiving a condemnation award that results in a gain does not always mean you have to pay taxes on it immediately. The tax code allows for the deferral of tax on the gain from an “involuntary conversion” under Internal Revenue Code Section 1033. The principle of this deferral is the reinvestment of the condemnation proceeds, which allows you to maintain your investment without an immediate tax consequence.

If you reinvest the full amount of the proceeds into a suitable replacement property, you can defer the entire gain. Any portion of the condemnation proceeds not reinvested in a replacement property is taxable in the year you received the funds. The taxable amount is the lesser of your total realized gain or the amount of proceeds you did not reinvest.

Replacement Property and Period Requirements

To defer a gain from condemnation, you must adhere to IRS rules regarding the type of property you purchase and the timeline for doing so. Failure to meet these requirements can result in the gain becoming immediately taxable.

The primary standard for a replacement property is that it must be “similar or related in service or use” to the property that was condemned. This means an owner-operator of a condemned retail store would need to buy another property to operate a retail business. For an owner who leased out the condemned property, the replacement property must also be leased out, with similar management responsibilities and business risks.

A more flexible “like-kind” test applies to condemned real estate held for productive use in a trade or business or for investment. This test allows for a broader range of replacement options. For example, under the like-kind standard, a condemned office building could be replaced with undeveloped land held for investment.

The replacement period begins on the earlier of two dates: the date the property was disposed of or the date of the first written threat of condemnation. For most condemnations, the owner has two years after the close of the first tax year in which any part of the gain is realized to purchase a replacement. For condemned real property used in a business or held for investment, this period is extended to three years.

Reporting the Condemnation and Making the Election

Properly reporting the condemnation and electing to defer the gain are necessary steps. The choice to defer the gain is not automatic; you must make a specific election on your tax return for the year you realize the gain.

To make the election, you must attach a statement to your tax return that includes:

• A description of the property
• The date of the transaction
• The total proceeds received
• The calculation of your realized gain
• An explicit statement that you are choosing to defer the gain and intend to purchase a replacement property within the required period

The transaction is reported on Form 4797, Sales of Business Property. Even if you plan to defer the entire gain, you must still report the transaction on this form and indicate your election.

Once you acquire the replacement property, you must provide the IRS with the details of that purchase by filing another statement with the tax return for the year of the acquisition. This statement should describe the new property, its cost, and the date it was acquired. If you do not reinvest the full amount of the proceeds, you may need to file an amended return for the year of the condemnation to report the taxable portion of the gain and pay the corresponding tax.