WHAT IS AN INVOLUNTARY CONVERSION?
If insurance and other similar reimbursements in connection with the destruction of real and personal property exceed the cost basis of the property lost, a gain has been realized. Since the transaction was not voluntarily initiated by the party whose property was lost and there is a gain, it is called an “involuntary conversion.” What do you do with that gain? Once a determination has been made that a gain has been realized, a number of considerations must be reviewed and decisions must be made. First, in order for there to be a gain, a transaction must have taken place that converted property into something of value that is not “similar or related in service or use to the converted property.” Next, that conversion must not have been voluntary. In keeping with the purpose of this blog, that would be a fire, flood, earthquake or some other casualty transaction. Generally this means money.
CONVERSION INTO MONEY
Unlike a “like kind exchange” that requires the taxpayer to maintain the appearance of not handling any funds involved in the sale of the property disposed of and used to acquire the replacement property in order to avoid being taxed on the cash, otherwise called “boot.” Involuntary conversions assume that the taxpayer is in receipt of cash or other property that is not similar or related in service or use to the converted property. Where the conversion is into dissimilar property the nonrecognition of gain becomes an option:
… at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion (regardless of whether such amount is received in one or more taxable years) exceeds the cost of such other property or such stock.
IRS regulation states what must be done if the taxpayer fails to report the decision to defer or does not make a qualified replacement.
Failure to report transaction is an election to defer realized gain:
“Failure to report the transaction in the return of the year the gain arises is deemed to be an election to defer the gain even though the details in connection with the conversion are not reported in such return.”
However, the election to defer is only part of the process. The second part is the use of the proceeds to replace or repair the lost property with property that is “similar or related in service or use to the converted property.” That part of the process must be reported to the IRS in order for it to be considered a valid reinvestment of the proceeds.
Failing to reinvest proceeds after electing to defer gain:
If, after having made an election, the converted property is not replaced within the required period of time, or replacement is made at a cost lower than was anticipated at the time of the election, or a decision is made not to replace, the tax liability for the year or years for which the election was made shall be recomputed and reported on an amended return.
The regulations also allow for a change from recognizing the gain to deferring it:
Change to elect to defer after filing a return recognize gain has been filed:
If a decision is made to make an election after the filing of the return and the payment of the tax for the year or years in which any of the gain on an involuntary conversion is realized and before the expiration of the period within which the converted property must be replaced, a claim for credit or refund for such year or years should be filed.
If the replacement of the converted property occurs in a year or years in which none of the gain on the conversion is realized, all of the details in connection with such replacement shall be reported in the return for such year or years.
Assessment of a deficiency is made where the taxpayer made an election, but failed to fully invest the proceeds;
(5) .. may be assessed at any time before the expiration of three years from the date the district director with whom the return for such year has been filed is notified by the taxpayer of the replacement of the converted property or of an intention not to replace, or of a failure to replace, within the required period.
The paragraph goes on to re-state the reporting details needed if a replacement has been made. The regulations allow the taxpayer to:
… the taxpayer may, in either event, also notify such district director before the filing of such return.
This provision allows the taxpayer to start the three year statute running prior to filing a return for the year of completion of the conversion into qualified property.
A final paragraph covers the possibility of a qualified acquisition being completed in a year prior to the last year in which gains (proceeds) are realized:
(6) If a taxpayer makes an election and the replacement property or stock was purchased before the beginning of the last taxable year in which any part of the gain upon the conversion is realized, any deficiency, for any taxable year ending before such last taxable year, which is attributable to such election may be assessed at any time before the expiration of the period within which a deficiency for such last taxable year may be assessed.
The decision to recognize or defer a gain is not one that should not be made lightly. For individuals, the decision to elect deferral of the gain can be delayed for as long as 9½ months after the close of the year in which the gain is first realized by filing the tax return on extension, October 15th. This allows the taxpayer time to analyze the implications of the alternatives, reinvesting or simply paying taxes and “moving on with their lives.” If the replacement property is purchased in “year 2” after the year of the initial year when a gain was realized, but there is additional gain that is realized in “year 3,” a deficiency can be assessed through the expiration of “year 3’s” normal statute of limitations, not “year 2’s.” This extended statute of limitations applies to all years starting with the year of the event. (Reg. §1.1033(a)-2(c)(5))
Two issues arise that must address. If a gain is realized the normal exclusion of gain on the sale of a primary residence may apply. It is possible that the triple 2 year periods identified in law may not be fully met at the time of the event. There are provisions that may allow the taxpayer to a partial use of the exclusion. One restriction that cannot be overcome is that to use the provision, the residence must have been completely destroyed in the event that gave rise to the involuntary conversion.
INFORMATION REQUIRED TO BE REPORTED FOR INVOLUNTARY CONVERSIONS
The IRS does not have a proscribed form for reporting an involunatary conversion, including, the reinvestment of the proceeds. However, the following information must be reported in the appropriate tax returns:
· Event identification – clear description including any federal or state disaster declarations
· Year(s) gain realized – the gain may be realized in more than one year, each year of realization must be reported
· Identification of property lost - clear description including address of property for real property, for replacement properties the location, cost investment
· Dates of loss, reinvestment
· Election to defer gain under appropriate Code section
· Identification of replacement property(ies) or repairs – type of property, location
· Proceeds received Less Gain excluded = Gain realized
· Gain recognized (taxable / partial or full deferral)
The list seems daunting, but the actual process is not difficult when handled with the assistance of a knowledgeable tax professional.
All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.
Certified Public Accountant
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It All Adds Up For You
This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.
Internal Revenue Service Circular 230 Disclosure
This is a general discussion of tax law. The application of the law to specific facts may involve aspects that are not identical to the situations presented in this material. Relying on this material does not qualify as tax advice for purpose of mounting a defense of a tax position with the taxing authorities
The analysis of the tax consequences of any event is based on tax laws in effect at the time of the event.
This material was completed on the date of the posting
© 2012, John Trapani, CPA,