An eminent domain appraisal that values the whole property before the taking and the remainder after it is what the IRS expects behind a severance damage allocation. The allocation in the settlement is necessary but not sufficient on its own: without credible appraisal evidence that the retained parcel actually lost the value attributed to severance damages, the IRS can recharacterize the entire award as proceeds for the property taken, whatever the settlement says.
The standard the IRS applies
The IRS does not prescribe a single method for valuing severance damages, but the approach that consistently survives scrutiny is the before-and-after appraisal. The appraiser establishes the fair market value of the entire property immediately before the taking, then the fair market value of the retained remainder immediately after it. The difference, net of the value of the property physically taken, is the measure of severance damage.
The method is well established in condemnation law and in IRS practice. An appraiser who uses accepted valuation methods, documents the assumptions and reaches a before-and-after conclusion will generally produce work that survives review. The quality of the appraisal matters as much as its existence. Why the allocation itself has to be settled before closing is covered in our article on severance damages in eminent domain.
What does not hold up
Three approaches consistently fail IRS scrutiny and have been rejected by the Tax Court.
An allocation with no appraisal behind it. A settlement that allocates proceeds to severance damages without an independent appraisal to support the number is the most common and the most vulnerable position. The IRS treats the absence of support as evidence that the allocation was neither arm’s-length nor economically grounded, and the whole award becomes consideration for the property taken.
A round number with no documented method. An allocation that lands on a round figure reached through negotiation rather than appraisal raises immediate questions. The IRS will ask what the number is based on, and “we agreed to it” is not an answer. The allocation must trace to something measurable: a before-and-after value conclusion, a specific category of damage with a quantifiable effect, or an expert assessment of diminished use.
A retroactive appraisal. An appraisal commissioned after closing to justify an allocation already made is the weakest of the three. The Tax Court has viewed retroactive appraisals with skepticism, particularly where the appraiser was not involved in the negotiation and is working backward from a number already set. The IRS has challenged these successfully more than once.
What to document, and where
The supporting analysis, meaning the before-and-after appraisal, the identification of the severance damage components, and the documentation of the retained parcel’s adjusted basis, belongs in the owner’s close-out file. It should be organized and available if the IRS ever asks for it. It does not need to be attached to the settlement agreement.
Attaching a detailed appraisal to the settlement can create more problems than it solves, because it gives an examiner a precise roadmap for challenging individual line items. The settlement should state the allocation in dollar terms. The supporting work sits behind it in the file, ready to produce if needed.
The close-out file checklist. The file should hold: a before-and-after appraisal by a qualified appraiser using USPAP-compliant methodology; the identification of the severance damage components and the basis for valuing each; the documentation of the retained parcel’s adjusted basis before the taking; and the settlement agreement with explicit dollar allocations between the property taken and the severance damages. The file supports the tax position if it is ever examined; it is not part of the settlement. Our page for CPAs and attorneys lists what else the tax team will want in it.
Severance detail against Section 1033 flexibility
The appraisal exists to support the severance allocation, and the two have to be weighed together. Detailing the severance damages in the settlement agreement, or attaching the appraisal to it, can narrow the owner’s options under Section 1033: characterizations written into the agreement bind the owner later, and an itemized appraisal gives an examiner a line-by-line target. Bolstering a severance claim marginally is not worth losing a Section 1033 route that would have deferred far more. The allocation goes in the agreement in dollars; the appraisal stays in the file; and before either is fixed, the owner’s tax team should have looked at what the severance characterization does to the rest of the plan.
Getting the appraiser involved early
The most important timing decision in severance damage planning is when the appraiser enters the process. An appraiser involved before settlement negotiations begin can build the allocation from first principles, establishing the before-and-after difference and helping negotiate an allocation that is both defensible and as favorable as the facts allow.
An appraiser brought in afterward is working to justify a number already set, a much weaker position. If the owner is still at the table, now is the time. If the settlement has been signed without appraisal support, the options narrow considerably, though there may still be steps worth taking depending on the facts.
The key timing point. The appraisal should drive the allocation number, not the other way around. Get the appraiser involved before settlement negotiations conclude. Once the agreement is signed without appraisal support, the position becomes significantly harder to defend.
Where a tax specialist fits
We are not the owner’s attorney and we do not negotiate awards. We read the draft allocation against the retained parcel’s basis and the owner’s Section 1033 options before the settlement is signed, so the severance characterization helps the tax result instead of narrowing it. If the owner does not need us, we say so. The first call is free.
Frequently asked questions
What is a before-and-after appraisal? A valuation of the entire property immediately before the taking and of the remainder immediately after it. The difference, less the value of the part physically taken, measures the severance damage.
Does the appraisal have to be attached to the settlement? No, and it is almost always better that it is not. The settlement states the allocation in dollars; the appraisal and the supporting analysis stay in the owner’s close-out file.
What if the settlement was signed without an appraisal? The position is harder to defend, and a retroactive appraisal is the weakest support there is. Depending on the facts there may still be steps worth taking; it is a conversation to have promptly.
Still at the table on a partial taking? A free thirty-minute call with Steve Medendorp covers the appraisal and the documentation before the settlement closes.
