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.
JOHN TRAPANI
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Certified Public Accountant
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2975 E. Hillcrest Drive #403
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Thousand Oaks, CA 91362
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(805) 497-4411
E-mail John@TrapaniCPA.com
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Website: www.TrapaniCPA.com
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Blog: www.AccountantForDisasteRrecovery.com
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It All Adds Up For You
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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,
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