The process of taking property, by either a government or a private company, like a power utility, that has the right to take it, is referred to in tax parlance as an involuntary conversion. In a typical example, a landowner accepts money, either through the process of condemnation, or under threat of condemnation, for property or property rights.
An owner of real estate which is taken by involuntary conversion has the option of keeping the money and recognizing a long-term capital gain, as though the property had simply been sold, or he can use the money to purchase replacement property. If he elects not to replace the property, then the gain is calculated as being the difference between his cost basis in the property, and the condemnation proceeds. If he elects to spend all of the proceeds on replacement property, he generally has until December 31 of the second year after the year the proceeds were received. If the property was real estate used in a trade or business, he has until December 31 of the third year after the year the proceeds were received. If the entire proceeds are not used on replacement property, then the unused funds are taxed as a long-term capital gain in the year they were received.
In the year the money is received, if the owner is going to use the replacement option to avoid recognizing and paying tax on the money, he must provide information in his income tax return that describes the condemnation transaction, the plans for using the proceeds on replacement property, and make a positive election to postpone recognizing the gain. In the year the replacement property is obtained, a statement describing the replacement property, and referring back to the earlier year of the involuntary conversion should be attached to the tax return for that year.
Some types of payments are nontaxable. Relocation assistance is generally not taxable, and severance damages, which represent compensation for decrease in value of property which was not taken, can be treated as a reduction in the cost basis of the retained property, and may be nontaxable. In addition, condemnation proceeds for a principal residence are generally not taxable, unless the gain exceeds the allocable amount of the principal residence exclusion. This is usually $500,000 on a joint tax return, and $250,000 otherwise.
Additional situations and concepts relating to condemnation awards can be found in IRS Publication 544.