Are Condemnation Awards Taxable? Taxes on Eminent Domain Compensation
When the government takes your property, the award is treated as a sale for tax purposes. Here is when it is taxable, how severance damages and interest are handled, and how to defer the gain.
Key takeaways
- A condemnation is an involuntary conversion for tax purposes; your award is treated much like a sale.
- You have a taxable gain when the net condemnation award exceeds your adjusted basis in the property.
- Severance damages and interest on the award are treated separately, and interest is ordinary income.
- You can postpone the gain by reinvesting under Section 1033.
When the government takes your property through eminent domain, the payment you receive is not tax free. The IRS treats a condemnation, or a sale under threat of condemnation, as an involuntary conversion, which means the award is handled much like the sale of the property (IRS Publication 544).
When is a condemnation award taxable?
You have a taxable gain when the net condemnation award is more than your adjusted basis in the condemned property. The net award is what you are paid for the property after subtracting expenses of obtaining the award. Subtract your adjusted basis from that figure: if the result is positive, you have a gain; if negative, you may have a deductible loss depending on how the property was used (Publication 544).
Because the award can include recovered depreciation, part of the gain on business property may be taxed as depreciation recapture rather than at capital gains rates.
How are severance damages taxed?
When only part of your property is taken, you may receive severance damages for the loss in value to the part you keep. These are treated separately. Net severance damages equal the severance damages received minus any special assessments withheld from the award and minus your expenses of obtaining them. Net severance damages first reduce the basis of your remaining property, and any excess is treated as gain (Publication 544).
Interest and other components
If the condemning authority pays interest on the award because payment was delayed, that interest is ordinary income, not part of the property gain, and is taxed at ordinary rates. Careful allocation of a lump-sum award among property value, severance damages, and interest therefore has a direct tax effect.
Deferring the tax with Section 1033
You do not necessarily have to pay the tax in the year of the taking. Under Internal Revenue Code Section 1033, you can postpone reporting the gain if you reinvest the proceeds in qualifying replacement property that costs at least as much as the amount realized from the condemnation, within the replacement period. See our guide to 1033 exchanges for the rules and deadlines.
Sources
- IRS Publication 544, Sales and Other Dispositions of Assets
- 26 U.S.C. § 1033, Involuntary conversions
Frequently asked questions
Do I have to pay tax on an eminent domain payment?
Possibly. A condemnation is treated as an involuntary conversion, and you have a taxable gain when the net award exceeds your adjusted basis in the property. You may be able to defer that gain under Section 1033.
Are severance damages taxable?
Severance damages are handled separately. Net severance damages first reduce the basis of your remaining property, and any excess is treated as gain, per IRS Publication 544.
Is interest on my condemnation award taxable?
Yes. Interest paid because the award was delayed is ordinary income taxed at ordinary rates, separate from the gain on the property itself.
Can I avoid the tax entirely?
You can defer, not usually eliminate, the gain by reinvesting under Section 1033 within the replacement period. Deferral postpones the tax and carries your basis into the replacement property.
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