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Involuntary Conversion Rules Provide Opportunities for Alabama Hurricane Victims

Contents
How Does It Work?
A Comprehensive Involuntary Conversion Example
The Similar or Related In Service or Use Requirement
Special Rule for Presidentially Declared Disaster Areas
Involuntary Conversion of the Taxpayer's Principal Residence

In the early morning hours of Thursday, September 16, 2004, Hurricane Ivan struck the Alabama Gulf Coast a massive blow, leaving devastation from wind and water in its wake where only a few hours earlier one of the most beautiful and popular of Alabama's tourist attractions had flourished. Ivan pounded north the rest of that day, spreading destruction all the way to the Tennessee border and beyond. The recovery efforts began immediately in the hours after Ivan passed by; but realistic estimates are that it will be months, or even years, before all of the affected areas are back to anything approaching their pre-Ivan condition.

Alabamians suffered crippling property damage from Ivan - estimates run into the billions of dollars. Ironically, in some situations, the storm damage can also give rise to unexpected tax burdens. For example, when the insurance proceeds for damaged property are greater than the taxpayer's cost basis in that property, the property owner may have to pay capital gains tax on that excess. Similarly, when a land owner with a very low basis in his timber salvages and sells storm-damaged timber before he had planned to, he also may have to pay tax on the gains, perhaps years earlier than he had intended. In such situations, Alabama taxpayers should be familiar with the opportunities that Federal Code Section 1033 provides. 1033 has been incorporated by reference into the Alabama Code (40-18-8(d)), so taxpayers able to take advantage of its provisions will save or defer Alabama tax along with federal tax.


How Does It Work?

1033 deals with "involuntary conversions" of property used in a trade or business or held for investment, and with the involuntary conversion of a taxpayer's principal residence. Involuntary conversion is a legal term which includes destruction, theft, or condemnation, as well as some other unpleasant things that can happen to property. Damage or destruction by a hurricane clearly falls within the definition. If the proceeds (insurance reimbursement, for example) of an involuntary conversion are reinvested within a specified period of time in property that is "similar or related in service or use" to the converted property, the owner may elect to not recognize any gains he realized on the conversion. In general, the specified time for reinvestment begins with the date that the original property is disposed of or converted, and it ends two years after the close of the first tax year in which any of the gain on the conversion is realized.

As you might expect, the taxpayer does have to pay a price for the privilege of non-recognition in the form of a "carryover basis". His basis in the new property will be its cost, reduced by any gain realized on the old property that was not recognized.


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A Comprehensive Involuntary Conversion Example

An example might help to understand the concept. Let's assume that Mary Wilson owns rental property in Orange Beach that she paid $100,000 for in 1996. She has taken depreciation deductions since she's owned the property, and her adjusted basis in the property on September 15, 2004 was $75,000. The property is insured for $300,000, and was totally destroyed by Ivan. On December 15, 2004, Mary receives full payment from her insurance company on the claim.

If Mary simply puts the insurance proceeds in the bank, she will have a taxable gain of $225,000 ($300,000 - 75,000). All of that gain will be taxed at 5% on her 2004 Alabama return, resulting in a tax of about $11,250 ($225,000 X 5%). The federal results are even more unpleasant. $25,000 of the gain ($100,000 - 75,000) is due to depreciation deductions taken, and will be taxed as "Section 1250 gain" on Mary's federal return at 25%. The remainder of the gain is long-term capital gain which is taxed at 15%. Mary's total federal tax due as a result of the reimbursement for the storm damage is $36,250 ({25,000 X 25%}+{200,000 X 15%}), and the combined bill is $47,500 (11,250+36,250). After paying taxes, Mary will have $252,500 ($300,000 - 47,500) left to invest.

On the other hand, if Mary reinvests all of the $300,000 in property that is similar or related in service or use to her Orange Beach rental property, and if she acquires the new property no later than December 31, 2006, she can defer recognition of the gain described in the previous paragraph, at least until she disposes of the new property. Her basis in the new property will be $75,000 (Cost of $300,000 less deferred gains of 225,000). This means that Mary's depreciation deductions on the new property will be approximately the same as they would have been on the old property if it had not been destroyed by the storm, and also that any gain recognized on a subsequent sale will be measured by the lower basis.


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The Similar or Related in Service or Use Requirement

There is no definition in the Code or the Regulations of the phrase "similar or related in service or use", so taxpayers have to rely on guidance provided by the courts. The Tax Court has said that when a taxpayer's enjoyment of his property is interrupted without his consent, he can arrange to have that interruption ignored for tax purposes "... by returning as closely as possible to his original position."1 In other decisions, courts have held that in the following cases, replacement property was similar or related in service or use.

Conversely, the following replacement properties were found by the court to not meet the similar or related in service or use standard:


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Special Rule for Presidentially Declared Disaster Areas

1033(h)(2) was added by Congress as a stimulus to recovery efforts, and may be especially relevant to Alabama business-owners over the next few months. It provides that if property held for productive use in a trade or business or for investment is involuntarily converted due to a Presidentially declared disaster, then any tangible replacement property that is held for productive use in a trade or business will be deemed to be similar or related in service or use to the converted property, and funds invested in that tangible replacement property will qualify for non-recognition treatment. Converted property falls under this provision if it was converted by an event that resulted in a subsequent designation by the President of the United States that the area where the property was located is eligible for Federal assistance under the Disaster Relief and Emergency Assistance Act.4 See the Web Site of the Federal Emergency Management Agency (FEMA) for a listing of Alabama counties designated for disaster relief because of Ivan.

This could be a very significant provision. It means that a business person considering re-investing involuntary conversion proceeds has much more flexibility than she normally would. For example, assume that Martha Jones' rental office building in Mobile was destroyed by Ivan, and that the building was insured for $1,000,000. Since Mobile was declared a disaster area by The President after Hurricane Ivan, Martha could invest the conversion proceeds in inventory for her retail computer business, or delivery vehicles, or any other tangible property held for productive use in a trade or business. She could not, however, use the proceeds to acquire investment property, or intangible property, and obtain the non-recognition benefits of Section 1033.


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Involuntary Conversion of the Taxpayer's Principal Residence

1033 also applies to the involuntary conversion of a taxpayer's principal residence. However, since Section 121 of the Code already permits exclusion of $250,000 in gain on the disposition of the principal residence of a single taxpayer, and $500,000 for a married couple filing a joint return, the gain from conversion would have to exceed those levels in order for the taxpayer to even consider 1033. Assume that Ted and Molly Smith paid $100,000 in 1985 for their home in Fairhope, and had it insured for $700,000. If the home was completely destroyed by the storm, and the Smiths collected on their insurance claim during calendar year 2004, they would have a realized gain on the conversion of $600,000 (700,000 - 100,000). $500,000 of the gain would be excluded under 121, leaving $100,000 taxable gain unless the Smiths reinvested under 1033.

The amount of the gain excluded under 121 in the above example ($500,000) is subtracted from the proceeds of conversion to determine how much must be reinvested to defer gain recognition under 1033.5 This means that if the taxpayers invest as much as $200,000 (700,000 - 500,000) in a new principal residence by December 31, 2006, they will be able to defer the remaining $100,000 of gain under 1033.


There is no question that Hurrican Ivan was a major disaster for the people of the state of Alabama. However, Alabama taxpayers can mitigate the potentially harmful tax impact of the storm by taking advantage of the provisions of 1033. Readers are cautioned to consult with their personal tax advisor before acting on any of the ideas presented in this article. Each fact situation is different, and those differences could result in material differences in the results.


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1Maloof v. Commissioner of Internal Revenue, 65 TC 263

2Bittker, McMahon and Zelenak, Federal Income Taxation of Individuals,Paragraph 30.03[3]

3Ibid

4Internal Revenue Code Section 1033(h)(3)

5Internal Revenue Code Section 121(d)(5)(B)

This page last updated 10/4/04

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