Tax Consequences - Involuntary Conversions
Involuntary conversions can result from damage from an outside source, theft, condemnation, seizure, destruction, requisition or sale/exchange due to threat or condemnation of the property.
Under Section 1033 of the Internal Revenue Code (IRC), a taxpayer who incurs an involuntary conversion can postpone recognition of the gain realized from the conversion (an exception to the two-year holding period).
Why is it beneficial to postpone gain?
- No tax liability in the year of the conversion.
- Funds may be used for other investments.
In exchange for tax deferment, the basis of the replacement property is generally fixed at the same adjusted basis as the converted property. Replacement must typically be made within two years (some exceptions apply).
If insurance proceeds are less than the replacement value, then the excess invested increases the basis of the replacement property. Tax on the original gain is realized or incurred when the replacement property is actually sold.