DEFINITION of Involuntary Conversion
Involuntary conversion is a forced sale cycle that begins when you own property that is taken without your consent and ends when you receive cash or property as compensation. A common example of involuntary conversion occurs when fire or flood destroys your property and you receive insurance proceeds as compensation for your loss.
BREAKING DOWN Involuntary Conversion
A voluntary conversion occurs when you transact to sell, gift or exchange your property in exchange for agreed upon consideration. The “involuntary” part of involuntary conversion means you did not transact and you lost ownership of your property unexpectedly. The Internal Revenue Code (IRC) recognizes property lost under the following four situations as involuntary: 1) accidents, floods, fires, natural disasters or other casualty sometimes referred to as “Acts of God”; 2) thefts or fraud; 3) governmental takings for public use, known as condemnations; and 4) voluntary sales due to threat of condemnation.
The compensation you receive in exchange for the property you lose is the “conversion" part of involuntary conversion. Compensation covers cash or property received in insurance settlements, disaster relief, court judgments and condemnation awards. Condemnation awards are constitutionally mandated payments made by governmental or quasi-governmental agencies that take or threaten to take property for the public good. You could receive a condemnation award if, for example, you own property where a public utility plans to install public utility lines. Notification of formal plans to locate the lines on your property means the utility will ultimately take your property whether you like it or not. It amounts to a forced sale that qualifies as an involuntary conversion for federal tax purposes.
Taxation of Involuntary Conversions
Generally, you recognize capital gain or capital loss on conversion of your property, whether it was voluntary or involuntary. If you receive money as compensation for your lost property and you don't use that money to buy a replacement property, then the involuntary conversion will generally be treated like a sale. You subtract the converted property’s value from the compensation you received. The difference is your gain or loss.
Let’s say, for example, you paid $10,000 to buy a 1962 Chevrolet Impala. Later, you modified it with $15,000 of lowrider suspension and a $4,000 metal flake panel paint job. You earned rental income by booking it at muscle car shows and took $5,000 of depreciation on it. Your adjusted basis in the car is $24,000. Tragically, a freak hydraulic hop totals your Chevy in an accident. You make a claim on your insurance and the insurance company pays you $29,000. You decide to get out of the lowrider business and don’t replace the Chevy. You owe tax on the $5,000 difference between the $29,000 insurance proceeds and the Chevy’s $24,000 adjusted basis.
Deferral of Taxation by Replacement Property
The Internal Revenue Code (IRC) allows you to defer tax recognition of an involuntary conversion if you acquire qualifying replacement property within a specified time period. It does so by allowing you to transfer the lost property’s basis to the replacement property thereby postponing your recognition of tax until you sell the replacement property.
Let’s say, for example, you choose to stay in the lowrider business and use the $29,000 of insurance proceeds and $2,000 of your own money to buy a fully customized 1963 Ford Galaxie lowrider for $31,000. Because you used the insurance proceeds to buy a replacement, you don’t owe any tax. At least not yet. The Chevy’s $24,000 adjusted basis transfers to the Ford so that the tax is postponed. You compute the Ford’s $26,000 adjusted basis by adding the $24,000 adjusted basis transferred from the Chevy to the $31,000 purchase price you paid and then subtracting the $29,000 of insurance proceeds you received. You further adjust the Ford’s basis for $3,000 of depreciation you take on it. You decide to get out of the lowrider business and you sell the Ford for $30,000. You recognize a $7,000 capital gain on the difference between the Ford’s $30,000 sales proceeds and its $23,000 adjusted basis.
Non-deductibility of Certain Capital Losses
Involuntary conversions gains are taxable whether the property was used for business or personal purposes whereas involuntary conversion losses can be written off only if they are incurred in conjunction with casualty or theft or condemnation of business or investment property. Capital losses incurred for involuntary conversions of personal use property are not deductible.
In the case of your totaled Chevy, if the insurance company had instead paid you $20,000, then you would have a $4,000 capital loss computed by subtracting the $24,000 adjusted basis from the $20,000 insurance proceeds. Since the Chevy was business property, the loss is deductible. Had the car instead been your personal ride, then you would have have a non-deductible capital loss.
Involuntary Conversion of Principal residence
Involuntary conversion of your principal residence is a reportable event but not likely to be a taxable one. This is true even if you don’t buy a new home after losing your old one. The reason is that any capital gains are likely to be excluded by the Home Sale Gain Exclusion and capital losses are likely to be personal use property non-deductible losses.