Types of involuntary conversions
Generally, the tax code recognizes four kinds of involuntary conversions:
- property destroyed by fire, weather or some other hazard
- stolen property
- property taken by the government for public use, known as "condemned property"
- Property disposed of under the threat of condemnation
Receiving money or property as compensation for the loss is what makes a property a "conversion." This includes things such as:
- an insurance settlement
- a court judgment or a payment from the government that condemns a property
- Under the Constitution, governments can't take someone's property without paying for it.
If you get a replacement
Whether an involuntary conversion has a tax effect depends on what you receive as compensation for your loss, and what you do with it.
If you receive property similar to what you lost, the conversion generally won't affect your tax situation in the short term. The same is true if you receive money as compensation, and you use it to buy a replacement property for the one you lost.
So, for example, an insurance settlement that rebuilds a building you own after a fire or replaces your car after being destroyed in an accident normally wouldn't have any tax implications.
The same is true if the government forces you out of your house by condemnation but gives you money to buy a new home. In these cases, the involuntary conversions are often referred to as involuntary exchanges.
Cost basis transfers to the new property
If you receive similar property as compensation, or if you use the money you receive to buy a replacement, the adjusted basis of your lost property is simply transferred to your new property.
The adjusted basis of the original property is essentially your investment in that property—how much you have spent to acquire and improve it less any allowable basis-reducing deductions, such as depreciation.
This is important because it means you generally won't have to pay any taxes now if the value of the compensation you receive is greater than your adjusted basis in the property you lost.
Such a gain would be taxable if you sold the property rather than lost it in an involuntary conversion. Transferring the basis to the new property can defer any tax hit until you sell it.
When you don't replace the property
If you receive money as compensation for your lost property and you don't use that money to buy a replacement property, then the involuntary conversion will generally be treated like a sale.
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Subtract your adjusted basis from the compensation you receive. The difference is a usually taxable capital gain.
If the compensation is less than your basis, you likely have a capital loss, which you may be able to write off on your taxes.
- You can write off capital losses for involuntary conversions when property is stolen or destroyed.
- Capital losses from condemnations can be written off on your taxes only if the property was being used for business or investment.
- Capital losses on condemned property that you owned only for personal use cannot be written off.
Primary residence is an exception
Involuntary conversions of private homes are an exception to the rules.
According to the IRS, if the property you lose to involuntary conversion is your primary residence, generally, you will not have any tax consequences, even if you don't purchase a new home and realized a capital gain or loss.