How Can A Taking By Eminent Domain Affect Your Taxes?
Having your property taken from you against your will can be difficult by itself, but losing your property and paying additional taxes after the property is taken is a harsh reality that many property owners face when confronted with eminent domain. In a prior blog post, we explained that the government has the inherent right to “take” private property for public use, subject to the condition that it pays the property owner “just compensation,” i.e., the fair market value, for the property. Notwithstanding the legal and procedural difficulties surrounding eminent domain and the valuation of a particular parcel, tax questions frequently arise after “just compensation” has been paid to the property owner. This blog post is intended to be an overview regarding the potential tax issues that may arise following a governmental taking.
While our firm specializes in local municipal real property ad valorem taxation matters, we do not handle federal or state income taxation issues, and recommend that you consult with a law or accounting firm that does handle these matters should you have any specific taxation questions that may arise. However, here are some basic things to keep in mind if your property has been taken by eminent domain and you have received just compensation for the taking.
Generally, the Internal Revenue Code (“the Code”) considers the payment of compensation by a condemnor as an ordinary taxable sale of property, similar in some ways to a voluntary sale of property, because a condemnation involves the transfer of real estate title in exchange for payment. The Internal Revenue Service (“the IRS”), therefore, considers such compensation as a taxable “gain” if the compensation exceeds the present taxable basis for the property. Property owners should be aware of the fact that they may therefore face a tax liability when compensation is received for property taken by eminent domain.
The Code does offer some ways to ease this liability. Although compensation from a condemnation matter is generally subject to taxation, the Code contains an important provision in Section 1033 which allows for certain exceptions to that rule. Under Section 1033, property owners are eligible for the deferral of gains for tax purposes in the following circumstances:
- Their property is condemned, or there is a “threat of imminence” of condemnation;
- They replace the condemned property within a specified time period (typically two to three years); and
- The replacement property is “eligible property” Section 1033.
Section 1033 derives from the idea that a property owner typically has the opportunity to reinvest the proceeds from selling their property into similar property to defer the obligation to pay tax on the gains from the sale. It is important to note that the Section 1033 nonrecognition exception is not unlimited as it relates to condemned property. Specifically, Section 1033 may not apply to the following proceeds:
- Interest, including detention damages, delay damages and payments for delay in compensation;
- Lost business profits that could be treated as ordinary income;
- Compensation for destruction of property (under applicable circumstances); and
- Relocation costs and other expenses.
As noted above, whether a property owner will be taxed on gains resulting from compensation paid in an eminent domain proceeding should be evaluated by experienced tax accountants or counsel but a Section 1033 exchange has provided other property owners whose property has been taken with a viable approach to consider. Being faced with the threat of condemnation can be a stressful and confusing experience. However, competent counsel should be able to advise you through every step of the process, including any potential post-condemnation implications and the benefits of qualifying for exceptions under the Code. At McKirdy, Riskin, Olson & DellaPelle, P.C., we have more than 50 years of experience successfully representing clients faced with eminent domain and property tax issues. If you are confronted with the threat of eminent domain or have questions on how the taking of your property may be approached or handled given the possible post-condemnation tax implications, please feel free to contact us for a consultation.