Definition of Involuntary Conversion
Involuntary conversion generally refers to a forced payment for property when that property is damaged or stolen. It is a common insurance term. Involuntary conversions typically also have taxation implications.
In general, involuntary conversions can occur for both individuals and businesses. Capital gains associated with an involuntary conversion are subject to income tax for both individuals and businesses. Capital losses are not typically deductible for individuals under the Tax Cuts and Jobs Act legislation unless related to disasters declared by the president. Capital losses associated with involuntary conversions pertaining to business losses are usually deductible.
Breaking Down Involuntary Conversion
An involuntary conversion occurs when an owner loses their property unexpectedly but with certain provisions in place to cover their losses. An involuntary conversion is the opposite of a voluntary conversion. A voluntary conversion occurs when an owner sells, gifts, or generally exchanges their property under agreed upon terms usually with an agreed upon monetary value.
Involuntary conversions can occur when any type of individual or business property is damaged or stolen. Property owners can take steps to mitigate the risk of involuntary losses through insurance policies. Any compensation an owner receives in exchange for property lost is associated with the “conversion" part of an involuntary conversion. Conversions may include cash payments from insurance policies and potentially accounting for replacement property. Without an insurance policy or other conversion agreement in place, involuntary damages or theft would simply result in a loss.
- Involuntary conversions refer to forced payments for property when property is damaged or stolen.
- Involuntary conversions can occur for both individuals and businesses.
- Entities usually take steps to mitigate involuntary losses and provide for involuntary conversation payouts through property and casualty insurance policies.
- Gains and losses from involuntary conversions may be necessary to report in annual tax filings for both individuals and businesses with slightly differing requirements by entity.
Property and casualty (P&C) insurance companies are typically the primary entities an owner can turn to for insurance policies that provide monetary compensation for involuntary losses. Property and casualty insurance companies can specialize in the areas of: auto, boat, home, and real estate. Individuals and business owners can pay a monthly premium to P&C companies for different types of policies that provide different amounts of monetary compensation in the event of an involuntary loss.
In cases where loans help to buy property, some lenders may require that an owner have a specified level of insurance coverage. Homeowner insurance is usually required with a mortgage and often suggested to cover the value of a home in the case of a casualty.
Other Conversion Payments
Compensation or replacement property can also be provided through means other than insurance. Other situations where a cash conversion may be provided from damages or theft can include 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 requires a condemnation payment and qualifies as an involuntary conversion.
Taxation of Involuntary Conversions
Section 1033 of U.S. Code Title 26: Internal Revenue Code discusses guidance for involuntary conversions. Generally the tax code discusses situations involving: 1) accidents, floods, fires, natural disasters, or other casualties 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.
In general, involuntary conversions can occur for both individuals and businesses. However, tax treatment can differ.
Capital gains are subject to income tax for both individuals and businesses. Capital losses are not typically deductible for individuals under the Tax Cuts and Jobs Act legislation unless related to disasters declared by the president. Capital losses associated with involuntary conversions pertaining to business losses are usually deductible.
Replacement property choices can play a part in the amount of gain or loss that is reported. When determining gain and loss for financial reporting purposes you will need to start with the market value of the lost property, also called conversion value, and the value you receive as compensation.
If you receive compensation greater than the conversion market value, you can apply that to replacement property. If you receive money as compensation for your lost property and you don't use that money to buy replacement property, then your capital gain will typically be the gain you received beyond the conversion market value.
Let’s say, for example, you have a 1962 Chevrolet Impala. The market conversion value on the car is $24,000. Tragically, your Chevy is totaled in an accident. You make a claim on your insurance and the insurance company pays you $29,000. You decide not to replace the Chevy and to pocket the cash. You will owe tax on the $5,000 difference between the $29,000 insurance proceeds and the Chevy’s $24,000 value.
If you replaced the Chevy with a similar vehicle, your gain from a $29,000 payout would still theoretically be $5,000 but you generally would not have to recognize it as a gain since you used it for the purchase of replacement property. The book value of the new vehicle would still typically be $24,000.
In some situations you may experience losses related to an involuntary conversion. If you receive less than the property’s market value in an involuntary conversion, the difference in market value and conversion compensation will be your loss. The Tax Cuts and Jobs Act generally eliminated Schedule A miscellaneous itemized deductions so your losses would typically not be eligible for itemization unless associated with a disaster declared by the president.
If a loss is business related it can be deducted. Property losses may be deducted at their carrying value if no conversion compensation is provided. Typically an owner could deduct the difference in an insurance payout and the carrying value if compensation does not cover the full loss. The same loss calculations could apply if partial compensation is used for replacement property. Business owners should consult a tax advisor to discuss individual situations and to determine the exact carrying value of replacement property with partial compensation.
Section 1033 of U.S. Code Title 26: Internal Revenue Code discusses deferral of taxation by replacement property which may arise as a concern.
The Internal Revenue Code (IRC) allows for deferral of tax recognition on an involuntary conversion if you acquire qualifying replacement property within two years. If you plan to purchase replacement property with conversion compensation you have two years to do so and must recognize a gain or loss on the property where applicable within that timeframe.