One of the issues that comes up frequently in eminent domain is whether the proceeds a property or business owner will receive from the government is treated as ordinary income, capital gains or is exempt from federal and/or state taxes. And when eminent domain attorneys get that question, they almost always start with the largely unhelpful response of “it depends.” But it really does depend on exactly what the money is, how the property was held, how the money will be used and whether we are talking about state or federal taxes.
Now, I could spend a lot of time trying to walk through all the scenarios and how it works, but fortunately, I do not have to do that. Instead, my partner, Douglas Schwartz, has already done all the hard work for me, creating a really helpful matrix that walks through various scenarios that typically occur. Now I'm sure Doug would tell me to tell you that this is not tax advice and that you should seek out a tax professional if you are facing condemnation (and he'd be correct, because every situation is a bit different), but hopefully you will find this helpful – and it really does cover most situations we see. In any event, here is Doug's matrix:
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(1) How are eminent domain payments taxed? |
If the proceeds are for … |
… then the tax treatment is |
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(a) principal or vacation residence |
Long-term capital gain if held for more than 1 year (23.8% federal, up to 12.3% California) |
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(b) property used for agriculture, investment, or business, and buildings |
Long-term capital gain if held for more than 1 year (23.8% federal (28.8% to extent of “recapture” of prior depreciation), up to 12.3% California) |
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(c) depreciable other property (fences, orchard trees, etc.) |
Ordinary income to extent of “recapture” of prior depreciation (up to 37% federal, 12.3% California) |
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(d) annual crops (nuts/ fruit on trees, “in ground”, etc.) |
Ordinary income as if owner had harvested and sold the crops (up to 37% federal, 12.3% California) |
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(e) relocation expenses |
Not taxable |
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(2) Can I exclude (or at least defer) taxable gains or income in “(1)(a)” through “(1)(d)” above? |
(a) In “(1)(a)” above, you may be able to exclude up to $500,000 of gain for a principal residence (but not a vacation home) depending on how long you occupied it under Internal Revenue Code (“Code”) section 121 |
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(b) In “(1)(b)” and “(1)(c)”above, you may be able to defer tax under Code section 1033 if you use the eminent domain proceeds to purchase replacement property used for business or investment, or “similar in use” to the property condemned, within 2 years after the year in which you received the proceeds (though you can ask the IRS for one and perhaps even two 1-year extensions) |
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(c) In “(1)(a)” or “(1)(d)” above, you may be able to defer tax under Code section 1033 if you use the eminent domain proceeds to purchase property “similar in use” to the property condemned |
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(3) What if part of my property is condemned, and I receive additional “severance” damages for the diminution in value of the rest? |
Under IRS Revenue Ruling 83-49, you would allocate your “basis” in the overall property (i.e., original purchase cost, plus additional investment, less depreciation) to the parcel you keep and the parcel you don't keep based on their relative fair market values; reduce the basis allocated to the property you keep (but not below zero) by the severance damages; and treat any remaining severance damages as gain. You can defer this gain under Code section 1033, under the same principles as in ”(2)(b)” and “(2)(c)” above. (Revenue Ruling 83-49 gives an example of how this calculation works.) |
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(4) Can I keep my lower assessed value for California property tax purposes from the property I lost if I acquire replacement property?? |
Generally yes, provided you apply to the assessor's office of the county where your replacement property is located and the replacement property is “similar in size, utility, and function” to the property taken. “[S]imilar in size” for this purpose means that the value of the replacement property is no more than 1.2 times the value of the property taken. For more information see California Board of Equalization (“BOE”) Rule 462.500 and sample BOE Form 68 Claim for Base Year Value Transfer – Acquisition by Public Entity (each county will have its own form) |
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One thing I did want to note about the matrix is the various references to Internal Revenue Code section 1033. Many of you are likely familiar with the phrase “1031 exchange.” IRS Code Section 1031 is a provision that property investors can utilize to defer tax on the sale of investment property by rolling the sale proceeds into a new investment property. Section 1033 is similar, but it applies specifically in the context of property being acquired by eminent domain or under threat of condemnation, and it includes some differences from Section 1031 that can be favorable to owners, including providing owners with more time to complete the transaction.
Having said that, there are a few situations in which Section 1031 can be more advantageous than Section 1033, and a condemnee is always free to complete a “1031 exchange,” even in the context of a condemnation, if that is more favorable than a “1033 exchange.” Again, this is an area where consulting a qualified tax professional is crucially important, because one misstep can invalidate a 1031/1033 exchange with expensive tax consequences.
Hopefully this clears up most of the common questions concerning the tax implications of an eminent domain proceeding.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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