Section 1033 Condemnation Sales & § 1031 Replacement Rules

A "condemnation sale" of property under IRC §1033 is not taxed if the taxpayer replaces with qualifying replacement property within specified time limits. Following is a summary of the more important rules to qualify for this tax treatment.

What Is A Condemnation Sale?

The involuntary conversion rules permit taxpayers who sell under the threat of condemnation to defer the gain on the sale (Code Section 1033(a) & Reg. Section1.1033(a)-1(a)). The IRS' position is that the threat of condemnation exists when the taxpayer learns through a reliable source that a governmental or quasi-governmental entity has decided to acquire the taxpayer's property, but only if there are reasonable grounds to believe that the condemnation or requisition will actually occur. The threat or imminence of condemnation thus exists if a taxpayer is faced with the alternative of either selling the property to the government, a quasi-governmental entity, or a third party; or having the property condemned.

What is a “Friendly Threat of Condemnation?”

Taxpayers often want to sell and are negotiating the sale of a property to a governmental entity and desire to take advantage of tax deferral under Code Section 1033. In order to qualify for the Section 1031 deferral, taxpayers must establish a “threat of condemnation.” One way to do this is to request from the governmental entity a “Friendly Threat of Condemnation” letter which informs the taxpayer that a condemnation is being considered if the sale negotiation falls thru. Governmental entities are usually cooperative with the taxpayer with this type of request.

What Is The Replacement Time Frame?

Taxpayers are granted three-years (IRC §1033(g)(4)) in which to replace real estate used in a trade or business (i.e. farm property). The three-year period commences with the earlier of the closing of the sale or threat of condemnation (IRC §1033(a)(2)(B)) and ends on the third anniversary of the end of the year in which the sale took place. Any other type of property disposed of in a condemnation sale is required to be replaced within two-years from the end of the year in which the sale took place. Extensions of time can be obtained by written request if necessary.

What Is Qualified Replacement Property?

For real estate used for investment or business purposes, qualified replacement property is "like-kind property" as defined under the rules of IRC §1031 tax-deferred exchanges (Reg. §1.1033(g)-1(a)). This means that any type of real property held for investment purposes will qualify for replacement of the sale of your farm land. The replacement property may be improved or unimproved under these rules. It is even possible to construct improvements on land a taxpayer is already in title on.

Does The Sale Cash Have To Be Escrowed Anywhere Under §1033?

There are no requirements for escrowing cash received from a condemnation sale under §1033. Taxpayers can use the cash as they wish. The replacement property can be 100% financed without using any of the cash you received from the sale of the condemnation property. There are no requirements for use of the condemnation sale cash for closing on replacement real estate.

How Do I Make A § 1033 Election and Report A Condemnation Sale On My Tax Return?

The condemnation sale should be reported on Form 4797 and the gain should be noted as "suspended under §1033." This will comply with the requirements for making an election to defer gain under §1033 as well as comply with the reporting requirements.

Additional Comments Regarding The Sale Of Personal Property

The §1031 and §1033 rules are generally very liberal as to what constitutes like-kind replacement property for real estate exchanges. The rules for replacement of Personal Property under §1033 are more restrictive. Under IRC §1033 replacement personal property must be "similar in use." Safe harbor like-kind replacement property for exchanges of personal property are provided under the General Asset Classes and Product Classes described below.

The General Asset Classes are found in the Regulations (§1.1031(a)-2(b)(2)). The Product Classes are found in Sectors 31, 32 and 33 (pertaining to manufacturing industries) of the North American Industry Classification System (NAICS) set forth in Executive Office of the President, Office of Management and Budget, North American Industry Classification System, United States, 2007 (NAICS Manual) as periodically updated.

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