Question Of The Week

REG: Involuntary Conversion

Dawson, Inc.'s warehouse (with an adjusted tax basis of $75,000) was destroyed by fire. The following year, Dawson received insurance proceeds of $195,000 and acquired a new warehouse for $167,000. Dawson elected to recognize the minimum gain possible. What is Dawson's basis in the new warehouse?

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A. $47,000
B. $75,000
C. $139,000
D. $167,000

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Explanation

An involuntary conversionWhen property is destroyed (eg, fire, tornado), stolen, or condemned by governmental authority. occurs when property is partially or wholly destroyed (eg, by fire or weather), stolen, or seized (eg, eminent domain The power of a government to force a property owner to sell the property to the government so it can be used for government purposes (eg, building a highway).) by a government. An indirect conversion is when a monetary settlement rather than replacement property is received.

For an indirect conversion, the taxpayer can elect to defer (ie, postpone) part or all the realized gain An amount signifying the difference between the value of proceeds received and the adjusted basis of surrendered property. This may differ from the amount reported or used in a tax computation. if a taxpayer acquires qualified replacement propertyProperty acquired that is similar or related in service or use to the property involuntarily converted. within the statutory time period. However, the taxpayer will recognize a realized gain to the extent the proceeds received are not reinvested in qualified replacement property. Basis of the replacement property equals its purchase price less any deferred gain, not the recognized gain.

Note: A shortcut is to remember that the basis of the replacement property equals the adjusted basis The cost of acquiring, making ready, and placing in service an asset less any adjustments (eg, accelerated expensing, accumulated depreciation, write-offs). of the converted property because the taxpayer's overall economic position has not changed.

In this scenario, Dawson, Inc. has a $120,000 realized gain, of which $28,000 is recognized. The basis of replacement property is $75,000 as shown below.

Cash proceeds	$195,000
Less: adjusted basis of converted property	$75,000
Realized gain		$120,000
Cash proceeds	$195,000
Less: cost of replacement property	$167,000
Less: uninvested proceeds (gain recognized)		$28,000
Deferred gain		$92,000
Basis of replacement property = $167,000 − $92,000 = $75,000*
*Adjusted basis of converted property

Things to remember:
For an indirect involuntary conversion, any gain recognized is the lesser of the realized gain or any proceeds not invested in the replacement property. The basis of the replacement property equals its cost less any deferred gain, which equals the adjusted basis of the converted property.

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