One of the issues that comes up frequently in eminent domain is whether the proceeds a property or business owner will receive from the government is treated as ordinary income, capital gains or is exempt from federal and/or state taxes. And when eminent domain attorneys get that question, they almost always start with the largely unhelpful response of “it depends.” But it really does depend on exactly what the money is, how the property was held, how the money will be used and whether we are talking about state or federal taxes.
Now, I could spend a lot of time trying to walk through all the scenarios and how it works, but fortunately, I do not have to do that. Instead, my partner, Douglas Schwartz, has already done all the hard work for me, creating a really helpful matrix that walks through various scenarios that typically occur. Now I’m sure Doug would tell me to tell you that this is not tax advice and that you should seek out a tax professional if you are facing condemnation (and he’d be correct, because every situation is a bit different), but hopefully you will find this helpful – and it really does cover most situations we see. In any event, here is Doug’s matrix:
One thing I did want to note about the matrix is the various references to Internal Revenue Code section 1033. Many of you are likely familiar with the phrase “1031 exchange.” IRS Code Section 1031 is a provision that property investors can utilize to defer tax on the sale of investment property by rolling the sale proceeds into a new investment property. Section 1033 is similar, but it applies specifically in the context of property being acquired by eminent domain or under threat of condemnation, and it includes some differences from Section 1031 that can be favorable to owners, including providing owners with more time to complete the transaction.
Having said that, there are a few situations in which Section 1031 can be more advantageous than Section 1033, and a condemnee is always free to complete a “1031 exchange,” even in the context of a condemnation, if that is more favorable than a “1033 exchange.” Again, this is an area where consulting a qualified tax professional is crucially important, because one misstep can invalidate a 1031/1033 exchange with expensive tax consequences.
Hopefully this clears up most of the common questions concerning the tax implications of an eminent domain proceeding.