When a property is destroyed, stolen, condemned (i.e. taken away by the government), or disposed of under the threat of condemnation and the taxpayer receives money or other property in return, the property is said to have been involuntarily converted. The taxpayer may be able to defer the recognition of gain from the involuntary conversion in certain situations.
When Is Gain From An Involuntary Conversion Deferred?
There are two situations where a taxpayer may defer the gain from an involuntary conversion:
- The taxpayer only receives property that is similar or related in service or use in return for the involuntarily converted property; or
- The taxpayer receives money or unlike property and buys a replacement property that is similar or related in service or use to the involuntarily converted property generally within 2 years after the year of the conversion.
Are There Differences Between These Two Situations?
Yes. Under situation #1, deferral of gain is mandatory if the only thing you get in return is property that is similar or related in service or use.
Under situation #2, the taxpayer may choose to defer the gain from an involuntary conversion by using the proceeds from the conversion to purchase a replacement property. Gain will be recognized to the extent that the proceeds from the conversion had not been used to purchase a replacement property.
For example: G receives insurance money of $5,000 for his car destroyed in a fire. G's basis in his car was $3,000. G uses $4,000 to purchase a car. G needs to recognize $1,000 since he realized a gain of $2,000 from the conversion ($5,000 - $3,000) and only used $4,000 of the $5,000 proceeds.
Are Losses Also Deferred In An Involuntary Conversion?
No. The involuntary conversion rules only apply to deferral of gains. Losses may be deductible if the involuntarily converted property was used in a business or for the production of income. Losses from personal use property, with the exception of theft, are generally not deductible.
What Is the Basis Of My New Property?
If your new property was acquired under situation #1, the basis of your new property is typically your basis in the involuntarily converted property.
If you purchased your new property under situation #2, the basis of your new property is the amount you paid for the new property less any gain not recognized from the involuntary conversion.
For example: G in the above example will have a basis of $3,000 for the car he purchased. ($4,000 cost - $1,000 gain not recognized)
Do I Need an Attorney to Help Me with My Tax Problems?
Tax laws are complex and ever-changing. Although there are various tax preparation softwares on the market that may help you with your tax problems, they cannot provide the same level of service that an experienced and knowledgeable tax attorney can. If you are unsure about the characterization of your losses or you need someone to represent you before the IRS, a tax attorney can help you.