IRS Definition of Involuntary Conversion
When you sell a property, the Internal Revenue Service considers it a conversion because you're converting property into money. When the conversion occurs because you actively decided to sell the property, it's considered a voluntary conversion. On the other hand, if the property is taken from you for another reason or if you sell it under duress, it's an involuntary conversion. Casualty losses and condemnations are both common types of involuntary conversions.
When a government agency or a private organization working under the government's sanction takes your property without your permission, it's considered a condemnation. For example, if the government takes over your house through eminent domain so that a developer can build shops or a marina, it's a condemnation. Selling your property to another party when you're under a threat of condemnation is also considered an involuntary conversion. While you might be selling it voluntarily, you're doing it because the threat of condemnation is forcing your hand.
Taxes and Condemnations
Gains from condemnation sales can be taxable, but the rules are a bit different from regular conversions. For instance, if you are forced to sell your house, you'll be able to claim the same $250,000 or $500,000 capital gain, depending on whether you're single or married, that you would with any other sale. However, if you make more than the exclusion amount, you can defer paying taxes on the overage as long as you spend it on a replacement property. In other words, if your house is sold for $650,000, and $550,000 of it is profit, as long as you buy another $650,000 home, you won't have to pay any taxes on it. You will, however, have to reduce your basis in the new home by $50,000 for the "extra" profit that you didn't have to pay taxes on. With investment properties, you have three years to buy a replacement property and use the extra money on it.
Casualty and Theft Losses
The IRS also regards casualty and theft losses as involuntary conversions. A casualty is an unusual, sudden or unexpected event such as an earthquake, fire, flood, storm or terrorist attack. A theft loss occurs when your property is stolen, including both physical losses through burglary or robbery, as well as losses caused by embezzlement, fraud or misrepresentation. In either case, your property is losing value in a way that you didn't plan to happen.
Taxes and Losses
Generally, you're able to deduct from your taxes any casualty or theft losses that you actually suffer at your property. You'll need to be able to prove and quantify your loss. In addition, you'll have to reduce your loss by any salvage value that you receive. For example, if your house is destroyed, but you're able to resell the lot, that lot's value would go into your salvage value. You also subtract any insurance reimbursements that you receive. Anything that is left is deductible as an itemized deduction. Personal losses are only deductible to the extent that they're more than 10 percent of your adjusted gross income, after subtracting $100. Business losses are generally, but not always, not subject to these limits.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.