To date, much has been written and said about California’s proposed high speed rail line. Much of its virtues and vices have been debated, scrutinized, editorialized and even litigated over for years. One aspect, however, has remained virtually unexamined—namely, the hefty tax bill imposed on property owners who sell to the rail authority. As odd and as unreasonable as it may sound, the government can take your property and then tax you on the gain you realized from that taking. For an unsuspecting owner, this can be devastating.
While there are rules under the Internal Revenue Code that can limit or delay the imposition of taxes in these circumstances, they are not for the faint of heart and must be followed with precision. For example, the Code provides that if a landowner purchases qualified replacement property within an applicable 2- or 3-year window, the gain (and ultimately the tax) on the condemnation sale will be deferred. Unfortunately, however, a single award of condemnation or sale proceeds will often consist of varying categories of payments such as compensation for real property, personal property and equipment, loss of business goodwill, severance damages, interest, and even moving and relocation expenses. These various payment categories have their own unique rules, time periods and reinvestment requirements that impact a landowner’s ability to defer taxes. Often, owners agree to settlements or court awards with the rail authority with little thought given as to how the dollars should be allocated between the various compensation categories. When that occurs, the owner is “locked-in” and must deal with the tax consequences, whatever they may be, even though a simple readjustment of dollars across certain categories could have proved beneficial.
Consider the following oversimplified example which hardly scratches at the surface of all the issues involved. If a restaurateur owns a restaurant and sells the restaurant land and building to the rail authority for $1million, the owner will generally have 3 years to purchase replacement real property (whether improved or unimproved) to be used in any trade or business (restaurant-related or not). However, if that same restaurateur is also given $50,000 for the price of restaurant equipment, then he or she will have 2 years to reinvest that $50,000 and the property purchased must essentially consist of replacement restaurant equipment. Alternatively, if the same restaurateur took the $1 million dollars and decided to build a new building on property he or she already owned, the tax affect would depend on whether the restaurateur built a new restaurant or some other building—generally, to qualify for deferral, the restaurateur would need to build a new restaurant within 2 years.
Even the question of when the applicable 2- or 3-year window begins to run is not entirely obvious and can ensnare an owner. While you would think it would begin at or around the time the owner actually received money in hand, the courts have stated that condemnation proceeds deposited with the courts--even while the land owner is litigating over the purchase price--will be deemed accessible by the landowner for purposes of triggering the applicable time period. As a result, it is not unheard of for landowners to miss the window of opportunity because of prolonged litigation or their difficulty in finding acceptable replacement property. While the IRS may grant extensions to the 2- or 3-year period, they are limited, must be applied for, and must properly document why an extension is justified.
The morass of tax rules and requirements briefly highlighted above will no doubt cause additional consternation and worry to already fatigued landowners. Not only will they be faced with difficult questions concerning a fair purchase price, the appropriateness of litigation, and finding a new business location but they will further have to grapple with complex IRS rules if they wish to defer taxes on the sale. Compound these complications with the fact that most land owners will not even receive enough in sale proceeds to re-open their businesses elsewhere and it appears landowners are getting a raw deal.