Tax

Out of Its Misery: Recording Gains on Condemned Property

New light was shed on an old sore spot last week when the IRS released its newest private letter ruling on "involuntary conversions."
Robert WillensFebruary 24, 2009

Bob Willens 2

Owning condemned property presents some interesting issues with regard to tax strategies, and a private letter ruling released last week by the Internal Revenue Services goes a long way toward answering many of the associated questions.

In general, condemned property triggers an “involuntary conversion” transaction, in which the gain from the transaction can be deferred under certain circumstances. For example, the gain can be deferred if, within a specified period, the taxpayer reinvests the conversion proceeds in property which is “similar or related in service or use” to the property so converted.

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In addition, the gain can be deferred if the proceeds are used to acquire control of a corporation which owns similar or related property. This condition raises a bevy of questions about the parameters of the acquisition of control, and a private letter ruling (LTR 200907007, November 5, 2008) released publicly on February 13, helps clear up some of the murkier issues.

In the letter’s example, the taxpayer is a corporation (BigCo) that owns “location X facility” (LXF), which is a parcel of improved real estate the company uses to conduct its trade or business. LXF was under “threat of condemnation” by a governmental agency that has the eminent domain powers to make good on its threat.

Under duress, the BigCo will sell LXF to the government agency, and realize a gain from the sale. Clearly, the taking of LXF by the government constitutes an involuntary conversion of LXF. Further, BigCo plans to defer the gain from the conversion of LXF by purchasing the common stock of TargetCorp that will be used as replacement property for LXF.

TargetCorp owns and operates business Alpha and business Beta, as well as “location Zeta facility,” a parcel of improved real property. During the replacement period, BigCo will purchase at least 80 percent of the voting power of all classes of TargetCorp’s stock entitled to vote, as well as 80 percent of the total number of shares of all other classes of TargetCorp’s stock.

The Zeta facility (including the personal property located and used at the facility) will comprise more than 90 percent of BigCo’s total assets. Also, it is undisputed that the Zeta facility constitutes property similar or related in service or use to the LXF.

The tax code, in Section 1033(a)(2)(A), states that if property is involuntarily converted into money – as in the case here – and the taxpayer purchases other property similar or related in service or use to the property converted or purchases stock in the acquisition of control of a corporation owning such other property, the gain (from the conversion) shall be recognized only to the extent that the amount realized (from the conversion) exceeds the cost of such other property or stock. Therefore, the recognized gain is the lesser of the realized gain, or the proceeds not reinvested during the replacement period. 

Addressing Knotty Problems

The letter ruling answers questions regarding the scope of the Section 1033(a) of the tax code that have never been previously addressed. It concludes that BigCo may acquire a controlling interest in TargetCorp through multiple purchases of the latter’s stock. What’s more, the ruling notes that neither the statutory or regulatory language limits the number of purchases a taxpayer may make within the replacement period in order to make a valid replacement of converted property.

The ruling continues that by the time BigCo gains control of TargetCorp, the latter will directly own property that is, with respect to LXF, similar or related in service or use. Although the property had been owned historically by a wholly-owned subsidiary of TargetCorp, the subsidiary will have merged with and into TargetCorp prior to the time BigCo gains control of TargetCorp.

Another, older ruling comes into play here regarding the issue of direct and indirect ownership. To be sure, a 1966 IRS revenue ruling (Revenue Ruling 66-33, 1966-1 C.B. 183) concluded that a valid replacement had not transpired. In the older example, the taxpayer whose property was converted purchased a controlling interest in a corporation that owned all of the stock of another corporation – which owned similar property to the converted property. The revenue ruling found that the precise requirements of Section 1033(a) were not satisfied because the taxpayer acquired control of a corporation that only indirectly held similar property through a subsidiary.

However, in the new November private letter rulling, the qualifying property will be held directly by the corporation the controlling interest in which is purchased.

Indeed, Section 1033(b)(2) says that in the case of property purchased by a taxpayer in a transaction described in the preceding section-Section 1033(a)(2)-the basis of the property is its cost decreased in the amount of gain not recognized. Further, Section 1033(b)(3)(A) refers to property held by a corporation the stock of which is replacement property. The section notes that if the basis of the stock is decreased, an amount equal to that decrease should be applied to reduce the basis of property held by the corporation “at the time taxpayer acquired control.”

The private letter ruling points out that that Section 1033(b)(3)(A) refers only to the property to which the basis reduction applies (the property held by the corporation at the time taxpayer acquired control.) It does not refer to the date on which the basis reduction computations are to be accomplished. The ruling concludes, therefore, that with respect to the computation date, the basis reductions should be made as of the day on which  LXF is sold to the government agency.

Finally, and most notably, the ruling observes that a taxpayer’s acquisition of stock qualifies under Section 1033(a) only if the taxpayer acquires control of a corporation with assets that consist “principally” (but not necessarily entirely) of similar or related property. (See Templeton v. Commissioner, 67 T.C. 518 (1976) and Rev. Rul. 69-242, 1969-1 C.B. 200.)

Moreover, the entire purchase price of the controlling interest is taken into account in determining the amount of gain deferred under Section 1033(a) even if the acquired corporation owns some “other property,” as is the case here. In the example, the ruling concludes that TargetCorp’s assets “principally” consist of property similar or related in service or use to the converted property because  the “dissimilar property” (business Alpha and business Betz) constitutes less than 10 percent (presumably by value) of BigCo’s total assets.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com

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