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Can a Voluntary Sale Be an Involuntary Conversion?

Does a voluntary sale ever qualify for Section 1033 treatment for the deferral of gain? Read about four sets of circumstances that qualify for this tax advantage.

September 25, 2008
Sponsored by BNA Software

by Nancy Faussett, CPA

Generally, for there to be an involuntary conversion under IRS Code Section 1033, the circumstances must be completely beyond the taxpayer's control. While you would think that a voluntary sale could never qualify for Section 1033 treatment for the deferral of gain, this is not always true. Whether or not it qualifies depends on each situation's particular set of circumstances.

Sales of Partially Destroyed Property

When property is partially destroyed, the taxpayer sometimes chooses to sell it as is, rather than repair it first. When this occurs, taxpayers may not defer the gain under Section 1033 because they do not have to sell it. When there is freedom of choice, Section 1033 will not apply to the sale.

The Tax Court case, C.G. Willis, Inc. v. Commissioner (41 T.C. 468 <1964>) addresses this issue. Willis owned a ship that was damaged in a collision and, preferring to replace the vessel, sold the damaged one. The taxpayer was not forced to sell the damaged vessel but simply preferred to replace it. Being a voluntary sale, the Tax Court denied Section 1033 treatment and deferment of the gain was not allowed.

In another case, Wheeler v. Commissioner (58 T.C. 459 <1972>), a fire damaged the taxpayer's building. The taxpayer chose to sell the entire shopping center in which the building was located rather than repair the damaged building. The Tax Court again denied Section 1033 treatment because repairing the damage was a reasonable alternative to the sale. (See Revenue Ruling 78-377.)

Sales Under Threat or Imminence of Condemnation

Generally, a sale of property under the threat or imminence of condemnation is considered an involuntary conversion.

For example, in Revenue Ruling 54-575, the IRS determined there was an involuntary conversion when a mobile home park was sold. The city had acquired an aviation easement over the land and imposed a restrictive covenant preventing use of the land for residential purposes. Since the taxpayer could not use the land for its intended purpose, the sale was considered an involuntary conversion.

Taxpayers have been allowed to defer gain under Section 1033 when reselling property, even though they knew that the property was under an existing threat of condemnation when they purchased it. (See IRS Revenue Ruling 81-181.)

Sometimes a taxpayer is contacted by an authority that has the power of condemnation and is asked to "voluntarily" sell certain property. In such a case, it is important to ascertain the likelihood that the condemnation will take place. If the authority simply wants to acquire the property, but does not intend to actually condemn it, then without an actual threat of condemnation, Section 1033 will not apply.

In another well known case, U.S. v. Wickersham (29 F.3d 191<1994>), the court criminally prosecuted a taxpayer who had conspired with a Texas government authority to sell his grain elevator at an inflated price. The taxpayer made false statements on his tax return regarding the threat of condemnation of the property and, in fact, the taxpayer sought a formal letter threatening condemnation after the sale agreement had been obtained.

Sales Under Certain Hazard Mitigation Programs

Code Section 1033(k) provides that a voluntary sale or exchange, after April 14, 2005, to any government agency to implement hazard mitigation under either the Robert T. Stafford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act is to be treated as an involuntary conversion.

Sales of Two Properties Together

It is sometimes possible to sell two properties together, in which one constitutes a voluntary sale while the other constitutes an involuntary conversion and defer the gain from their joint sale under Section 1033. For this to occur, however, the two properties must be considered a single economic unit.

In Masser v. Commissioner (30 T.C. 741 <1958>), the taxpayer owned two properties: a freight terminal and a vacant lot across the street that was used for parking the terminal's vehicles. When the parking lot property was condemned, the taxpayer was unable to find replacement property close to the terminal. Without the parking space, the terminal could not successfully operate. Therefore, the taxpayer sold both properties and used the proceeds from the sale, as well as the proceeds from the involuntary conversion, to purchase suitable replacement property.

In the Masser case, the two properties were considered a single economic unit with the involuntarily converted property making the other property unusable for its intended purpose. This allowed the sale of both properties under the provisions of Section 1033.

Conclusion

While most voluntary sales of property will not qualify for the deferral of gain under Section 1033, there is the possibility, depending on the circumstances that it will. Deferral of any gain is such an advantage that it is always important to research if it's possible.

Furthermore, if you use fixed asset management software, such software can help you with the sale, compute the gain, record the newly acquired property and provide an audit trail of the event.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.