Why Adjusted Basis Matters in Eminent Domain
Once an eminent domain settlement is reached, most property owners are concerned about one number: compensation. That number is obviously important because it represents the amount the government pays, but it does not show the real property’s taxable gain. Calculating that gain relies on another number many property owners don’t think about until tax time: the adjusted basis of their property.
It’s important for property owners to know their adjusted basis in order to understand how much of the condemnation award is taxable. Attorneys may therefore want to ask property owners at the time of client intake whether they have a CPA or tax advisor and encourage them to begin calculating basis as early as possible. Establishing a basis before an anticipated deposit can help the property owner and their advisors determine whether the deposit itself could create a gain and affect the timing of available tax-planning strategies.
Some property owners think the amount of taxable gain is just the difference between the property’s purchase price and the amount received from the government. However, computing the basis is often much more complex. The property’s tax basis can be impacted considerably by the number of years the property has been held in the owner’s possession as well as factors such as capital improvements, depreciation, and other adjustments, all of which determine the property’s amount of taxable gain.
Regrettably, many property owners don’t start thinking about a basis until tax season after the condemnation has already been finalized. At this stage, reviewing decades of ownership records may be more complicated than it would have been during settlement negotiations in the condemnation phase.
Why Basis Matters
One of the main factors in calculating the taxable gain after eminent domain is determining the property’s adjusted basis.
Example
For instance, assume two property owners each receive the same condemnation award for the full taking of similar properties.
The first owner acquired the property decades ago for a small fraction of today’s value and never made any major capital improvements. The second owner bought a similar property just a few years ago for close to what the government is now paying.
These owners are paid the same amount by the government, but the tax implications of their awards are very different. The first owner is likely to recognize almost all of the award as taxable gain, whereas the second owner may only recognize a relatively small amount of the award as taxable gain.
This example shows how calculating the adjusted basis for an eminent domain settlement is often one of the first questions to answer in determining the transaction’s tax consequences.
Original Cost Is Only the Starting Point
Many property owners think of basis as the purchase price when they originally acquired the property. Although this is where it usually starts, it often doesn’t stop there.
Basis can change depending on a number of factors. For example, basis tends to rise as a result of capital improvements, and tends to decline as depreciation is claimed over the life of the property.
The gap between original cost and adjusted basis can be quite large for a commercial property held for a long period of time. A property purchased decades ago may have increased in value while also experiencing a decrease in basis as a result of years of depreciation. This can cause two properties to have the same market value but yield widely different taxable gains at the time of condemnation.
Capital Improvements Can Increase Basis
One of the most common factors in determining adjusted basis involves capital improvements that have occurred over years of ownership. Capital improvements differ from routine repairs and maintenance because they generally increase the value of the property, prolong its use, or adapt it for a new use. These could include additions to buildings, parking lots, drainage, utilities, structural improvements, or significant site renovations.
To illustrate, assume an owner buys a commercial property and, over several years, adds qualifying capital improvements worth more than half the original purchase price.
Before depreciation, the adjusted basis is now more than one and a half times what the owner originally paid.
This shows why it’s important to maintain accurate records to keep track of major capital improvements to a property. It may be possible to determine a greater adjusted basis and lower taxable gain by relying on construction contracts, invoices, permits, and other documents.
Depreciation Can Lower Basis
In general, capital improvements add to basis, while depreciation may do just the opposite. For a property that produces income, the owner often claims depreciation on a property over a number of years. Those deductions may prove beneficial to the owner’s tax situation during ownership, but the deductions also cause a decrease in adjusted basis.
Suppose an owner put money into a commercial building through its purchase and later improvements, and over the years claimed depreciation equal to about a third of that total investment.
The adjusted basis is now about two thirds of what the owner put in. If the property is later condemned and the award is double that adjusted basis, half of the award is realized gain, and half of that gain traces back to the depreciation the owner claimed.
This is why so many commercial properties that are held for years and then sold generate so much more taxable gain than their owners may have expected.
Partial Takings Can Complicate the Calculation
Importantly, not all eminent domain cases involve the condemnation of an entire property. Many condemnation proceedings involve a partial taking, such as land required for the expansion of a highway, utility easements, drainage improvements, or widening a roadway. In those cases, calculating the basis can be significantly more complicated.
When only part of a property is condemned, the basis may not be adjusted based on that taking alone. Instead, it may be necessary to allocate the basis between the portion taken and the remaining portion. There are other factors that may also influence the tax analysis, such as severance damages or a decrease in the value of the remaining assets.
A lot of work goes into calculating what basis should be for a partial taking, so property owners should not assume that it only involves a simple comparison of the purchase price and settlement award.
Why Basis Should Be Calculated Early
One of the biggest mistakes property owners can make is waiting until tax season to calculate adjusted basis. By that point, years or even decades may have passed since the property was purchased. Depreciation schedules, closing statements, construction records, invoices, and improvement documentation may not be readily available.
Earlier calculation of basis offers more than just accurate tax reporting. It also gives both owners and their advisors a better idea of the potential tax liability prior to the completion of settlement. This awareness can help in conversations about tax-deferral options, replacement property planning, and other opportunities that may be available depending on the situation.
Knowing the basis before a deposit is made may also allow the property owner’s legal and tax advisors to consider how the deposit itself should be structured. Depending on the circumstances, this could include negotiating a deposit below the amount that would create a gain or considering whether a portion of the deposit should remain subject to restrictions. These issues should be evaluated carefully because an unrestricted deposit that creates a gain may begin the applicable reinvestment period before the final settlement is reached.
Conclusion: Calculate Basis Before Settlement
In an eminent domain case, the compensation amount is what the government must pay for the property. Adjusted basis helps determine how much the property owner will keep after taxes.
Calculating basis often involves more than just determining the original purchase price because of the possibility for the basis to change over the years of ownership. The final calculation may be impacted by capital improvements, depreciation, partial takings, and other adjustments.
As early as possible during the condemnation process, the property owner should gather purchase records, depreciation schedules, improvement records, and other financial documents. Knowing the adjusted basis before settlement will give property owners and their tax advisors a better idea of the tax implications of a condemnation award and allow time to evaluate planning opportunities before important deadlines arise. Our Tax Exposure Calculator gives a first rough estimate.
