The most expensive misunderstanding in condemnation tax planning is that a successful Section 1033 exchange eliminates depreciation recapture. It defers it, and one piece of it cannot be deferred at all. This issue takes the recapture question apart, then turns to the severance damages rule that next month’s issue builds on.
Section 1033 defers recapture; it does not eliminate it
The basis of the replacement property is reduced by the deferred gain, so the recapture follows the asset forward. Section 1250 recapture on depreciated buildings and structural components, taxed as unrecaptured Section 1250 gain at a maximum federal rate of 25 percent, rides along into the replacement and is owed when that property is sold. For commercial and income-producing property this is the largest number on the page, and it should be calculated before anyone shops for replacement property. Unrecaptured Section 1250 gain in a condemnation runs the two calculations side by side.
Section 1245 is the part that cannot wait
Section 1245 recapture applies to personal property and equipment: fencing, wells, irrigation, machinery, the things a pipeline easement across a working farm so often takes. It is ordinary income, computed before the Section 1231 analysis, and it is recognized in the year the proceeds are received even when every other dollar of gain is deferred under Section 1033. No structure changes that. The owner needs the number before signing so the cash is set aside rather than reinvested. Section 1245 recapture in a condemnation shows what counts and how it is reported.
Severance damages shield gain only when the allocation is in writing
When part of a parcel is taken, severance damages compensate for the loss in value of what remains. For tax purposes they are proceeds from an involuntary conversion of the remainder: they reduce the basis of the retained land first, and no gain is recognized until that basis is used up. For a low-basis remainder that absorbs a large share of the award. The condition is documentation. The allocation has to appear in the closing papers; it cannot be inferred or rebuilt afterward. Rev. Rul. 83-49 then lets severance damages that exceed basis be deferred into like-kind property beyond the retained parcel. Negotiate the allocation before closing has the sequence.
The first conversation: find the floor
Before the client looks at replacement property, determine the recapture exposure. It is the floor of what will be owed whatever happens next, and the rest of the plan builds from it. The free tax estimator gives a first look in about two minutes; the planning conversation belongs before the settlement is signed. Next month: how to negotiate the severance allocation, what appraisal evidence the IRS requires, and how to reinvest severance damages under Section 1033.
Is there equipment, fencing or irrigation in the taking? A free thirty-minute call with Steve Medendorp runs the recapture split before the award closes.
