Involuntary Conversions: Real Estate Tax Planning for Landlords

If, for whatever reason, your rental property is in serious disrepair and under threat of being condemned, you may receive compensation in the form of insurance payments or a condemnation award.

This is known as an involuntary conversion (or exchange) and, according to the IRS, it occurs when rental property is stolen, destroyed, condemned or disposed of under the threat of being condemned.

The IRS states, "a threat of condemnation exists if a representative of a government body or a public official authorized to acquire property for public use informs you the government body or official has decided to acquire your property. You must have reasonable grounds to believe that, if you do not sell voluntarily, your property will be condemned."

For tax purposes, you would generally report the gain or loss from an involuntary conversion during the tax year it happened. If you determine your net condemnation award is more than the adjusted basis of your condemned property, the IRS considers this a gain.

One way to postpone reporting a gain is to buy replacement property. Or, if only a portion of your property is condemned, the IRS allows you to treat the cost of restoring the remaining part to its former usefulness as the cost of replacement property.