Counselor, your job is the award; ours is what happens to it after the check clears, and the Section 1033 clock is the part of that story most files meet too late. This first issue of the Condemnation Tax Brief covers the ground every condemnation file stands on: the basic rule, the differences from a Section 1031 exchange, the lump-sum problem, and five questions worth asking before anyone signs.
Condemnation proceeds are taxable until the owner acts
When a government takes property and pays just compensation, the IRS treats it as a sale. If the award exceeds adjusted basis, the owner has gain: capital gains rates, depreciation recapture, and possibly the 3.8 percent net investment income tax. Section 1033 is the escape valve. Reinvest in qualifying replacement property within the window and the gain is deferred, but the election is not automatic; it has to be made, and the mechanics have to be right. The window is two years for most involuntary conversions and three for condemned real property held for business or investment, measured from the end of the first tax year in which any part of the gain is realized. That means a deposit, not the final award, can start the clock. The full sequence is in the Section 1033 election, step by step.
Section 1033 is not Section 1031
Clients who know Section 1031 assume Section 1033 works the same way. It does not. No qualified intermediary: the owner holds the proceeds. Two or three years instead of 45 and 180 days. Debt does not have to be replaced. Replacement property can be bought before the award is paid, as long as the purchase follows the threat of condemnation. And for business or investment real estate, Section 1033(g) borrows the like-kind standard, so the replacement does not have to match the use of what was taken. Holding the cash is also the risk: money spent before replacement property is identified is gain recognized. The comparison is laid out on the 1033 Exchange page.
A lump-sum award is an allocation problem
Most awards arrive as one number covering the property taken, severance damages to the remainder, interest, and sometimes business loss. Each piece is taxed differently, and the IRS will not let anyone reallocate after closing. If the agreement is silent, the whole award is presumed to be payment for the property taken. Severance damages reduce the basis of the land kept, interest is ordinary income that no Section 1033 election can defer, and lost profits are ordinary income too. The allocation has to be in writing before the papers are signed; the authority’s total does not change, the client’s tax does. Two articles carry the detail: severance damages and the allocation and interest on a condemnation award.
Five questions before settlement
What is the adjusted basis? Has the property been depreciated, on which assets and schedules? Is part of the award for a partial taking? Does the client want to reinvest or want cash? What is the character of the interest? The answers decide the recapture analysis, the severance allocation and the year of recognition, and they are easiest to get before the deposit is negotiated. Four questions for eminent domain attorneys before the deposit turns them into a routine, and the free tax estimator gives a first look at the size of the exposure in about two minutes.
Have a client between the notice and the deposit? A free thirty-minute call with Steve Medendorp puts the tax picture beside the legal one before the terms are set.
