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Apply Involuntary Conversion Rules - CPA Reg

  1. Under Section 1033, which of the following events qualifies as an involuntary conversion that may allow nonrecognition of gain?
    Answer: A taxpayer's warehouse is destroyed by fire and the taxpayer receives insurance proceeds exceeding the building's adjusted basis. Section 1033 applies to involuntary conversions resulting from destruction, theft, seizure, requisition, or condemnation of property. A fire-destroyed warehouse with insurance proceeds exceeding the adjusted basis creates a gain eligible for Section 1033 nonrecognition if qualifying replacement property is purchased within the applicable period. Answer A is a voluntary sale and does not qualify under Section 1033. Answer B describes a Section 1031 like-kind exchange, a separate nonrecognition provision. Answer C is a voluntary demolition and does not constitute an involuntary conversion under Section 1033.
  2. Holloway Corp owned a building used in its business (adjusted basis $240,000) that was condemned. The condemnation award was $400,000. Holloway reinvested $390,000 in qualifying replacement real property within the 3-year period and elects Section 1033(g). What is Holloway's basis in the replacement property?
    Answer: $240,000 Realized gain = $400,000 - $240,000 = $160,000. Recognized gain = $400,000 - $390,000 = $10,000. Deferred gain = $160,000 - $10,000 = $150,000. Basis of replacement property = cost - deferred gain = $390,000 - $150,000 = $240,000. Alternatively, basis = original adjusted basis + recognized gain = $240,000 + $10,000 - $10,000 = $240,000 (both methods confirm the same result). Answer B ($390,000) is the cost with no deferred gain adjustment. Answer C ($250,000) has no valid basis in the formula. Answer D ($150,000) is the deferred gain, not the basis.
  3. Tessa's personal residence was destroyed by a tornado. She received insurance proceeds of $450,000. Her adjusted basis in the home was $200,000. She purchases a new home for $420,000 within the two-year replacement period and elects Section 1033 without applying Section 121. How much gain must she recognize?
    Answer: $30,000 Realized gain = $450,000 - $200,000 = $250,000. Under Section 1033, recognized gain equals the excess of proceeds over the cost of replacement property: $450,000 - $420,000 = $30,000. Answer A ($250,000) is the total realized gain with no replacement offset. Answer C ($220,000) has no valid basis in the Section 1033 formula. Answer D ($0) would require reinvesting at least $450,000 in replacement property or applying the Section 121 exclusion to shelter the remaining gain.
  4. Under Section 1033, what is the treatment when a taxpayer realizes a loss because insurance proceeds are less than the adjusted basis of destroyed business property?
    Answer: The loss is recognized and deductible in the year of conversion; Section 1033 nonrecognition applies only to gains, not losses. Section 1033 is a gain nonrecognition provision only. When insurance proceeds are less than the adjusted basis of the converted property, no gain arises and Section 1033 does not apply. The loss is recognized in the year of conversion: for business property, it is treated as a Section 1231 loss; for personal property, it is subject to the Section 165 casualty loss limitations. Answer B is incorrect because Section 1033 does not defer losses. Answer C is incorrect; losses are not added to the basis of replacement property under Section 1033. Answer D is incorrect; involuntary losses on business property are generally deductible rather than disallowed.
  5. For most involuntary conversions of business property under Section 1033, what is the general replacement period within which qualifying replacement property must be purchased?
    Answer: 2 years after the close of the taxable year in which any part of the gain is realized. Under Section 1033(a)(2)(B), the general replacement period is 2 years after the close of the first taxable year in which any part of the gain is realized. A 3-year period applies only to condemnation of real property used in a trade or business or held for investment under Section 1033(g). Answer A (1 year) is too short and does not match the statute. Answer B (3 years) applies only to condemned real property, not to involuntary conversions generally. Answer D (5 years) is not a standard Section 1033 replacement period.
  6. A taxpayer's business land (held for more than one year, adjusted basis $150,000) is condemned by the city. The taxpayer receives $600,000 and does not purchase replacement property. What is the character of the $450,000 gain recognized?
    Answer: Section 1231 gain, because the land is a business asset held more than one year, which may qualify for long-term capital gain treatment. A condemnation is treated as a sale or exchange for tax purposes. Business land held more than one year is a Section 1231 asset, and the resulting gain is Section 1231 gain. When net Section 1231 gains exceed losses for the year, they are treated as long-term capital gain (subject to the 5-year lookback rule for prior unrecaptured ordinary losses). Answer A is incorrect; character is not affected by the identity of the condemning party. Answer B is incorrect because holding period rules apply normally; business land held more than one year produces long-term gain treatment, not short-term. Answer D is incorrect because Section 1250 recapture applies to depreciable real property, not to unimproved land.
  7. Mira's vacation cabin (adjusted basis $75,000) was destroyed by wildfire. She received $200,000 in insurance proceeds and purchased a replacement cabin for $175,000 within the two-year period. She elects Section 1033. What is the basis of Mira's replacement cabin?
    Answer: $75,000 Realized gain = $200,000 - $75,000 = $125,000. Recognized gain = $200,000 - $175,000 = $25,000. Deferred gain = $125,000 - $25,000 = $100,000. Basis of replacement cabin = cost - deferred gain = $175,000 - $100,000 = $75,000. This equals the original adjusted basis, reflecting that only $25,000 of gain was recognized and the remaining $100,000 of deferred gain is built into the replacement cabin's basis. Answer A ($175,000) is the cost with no adjustment for deferred gain. Answer C ($100,000) is the deferred gain amount. Answer D ($125,000) is the total realized gain, not the replacement basis.
  8. An investor-owner's apartment building was destroyed by fire. To satisfy the similar-or-related-in-service-or-use test under Section 1033, which of the following replacement properties would qualify?
    Answer: A new apartment building purchased to generate rental income from the same class of residential tenants. For an investor-owner, the similar-or-related-in-service-or-use test requires that the replacement property serve the same function and be used in the same way as the converted property. A residential rental apartment building replacing another residential apartment building serving the same class of tenants satisfies this standard. Answer B (commercial office building) serves a different function than a residential apartment building. Answer C (raw land) generates no rental income and is not in the same service or use as income-producing rental property. Answer D (retail shopping center) serves a fundamentally different tenant class and use than residential apartments.
  9. Alton's farm machinery (adjusted basis $13,000) was destroyed in a hailstorm. He received insurance proceeds of $25,000 and reinvested $22,000 in qualifying replacement machinery within the replacement period. Alton elects Section 1033. What is Alton's basis in the replacement machinery?
    Answer: $13,000 Realized gain = $25,000 - $13,000 = $12,000. Recognized gain = $25,000 - $22,000 = $3,000. Deferred gain = $12,000 - $3,000 = $9,000. Basis of replacement machinery = cost - deferred gain = $22,000 - $9,000 = $13,000. This equals Alton's original adjusted basis, confirming that the deferred gain is preserved inside the replacement property. Answer A ($10,000) has no basis in the Section 1033 formula. Answer C ($22,000) is the cost with no deferred gain adjustment. Answer D ($9,000) is the deferred gain itself, not the basis.
  10. Under Section 1033, how is the election to defer gain from an involuntary conversion into money properly made?
    Answer: By not reporting the gain on the return for the year the gain is realized, or by reporting it and filing an amended return to claim the deferral after replacement property is acquired within the replacement period. The Section 1033 election is made by either omitting the gain from the return for the year of realization (relying on the replacement to be made within the replacement period), or by reporting the gain and filing an amended return to claim a refund once qualifying replacement property is purchased within the period. The IRS permits flexibility in timing the formal election. Answer B is incorrect because Form 8824 is the Section 1031 like-kind exchange form, not the Section 1033 election form. Answer C is incorrect in requiring an advance attachment of a statement before replacement property is purchased. Answer D is incorrect because the election may be made or amended after replacement property is acquired, not only before the original return due date.
  11. Under Section 1033(b), when a corporation reinvests only part of the condemnation proceeds in replacement property, which of the following correctly describes the basis of the replacement property?
    Answer: The replacement property takes a cost basis reduced by the gain not recognized (deferred) under Section 1033. Under Section 1033(b), the basis of replacement property equals the cost of the replacement property reduced by the gain not recognized (deferred) under Section 1033. This mechanism preserves the deferred gain inside the replacement property so that it is recognized upon a subsequent taxable disposition. Answer A (FMV basis) is appropriate only when gain is fully recognized, not when gain is deferred. Answer B (original property's adjusted basis) would equal the replacement basis coincidentally only when all proceeds are reinvested and all gain is deferred, but is not the statutory formula. Answer C is incorrect because the cost must be reduced by the amount of deferred gain under Section 1033(b).
  12. A rancher's breeding livestock was sold due to an extended drought. Under Section 1033(e), which of the following correctly describes the involuntary conversion rules applicable to weather-related livestock sales?
    Answer: The replacement period is generally 4 years after the close of the first taxable year in which any part of the gain is realized, and replacement property may be livestock of a like kind or other property used for farming purposes Under Section 1033(e)(2), when livestock held for draft, breeding, or dairy purposes is sold due to drought, flood, or other weather conditions, the replacement period is 4 years after the close of the first taxable year in which any part of the gain is realized - significantly longer than the standard 2-year period. The IRS may further extend this period for areas that remain drought-designated. Qualifying replacement property includes livestock of a like kind or other property used for farming purposes, a broader standard than the general similar-or-related-in-service-or-use test. Answer D is correct. Answer A is incorrect because the standard is like-kind livestock or other farm property (not identical animals of the same breed), and the period is 4 years, not 1. Answer B is too broad in saying 'any farm property' without the like-kind livestock qualifier, and also states the wrong 1-year period. Answer C is incorrect; the 4-year period is the base replacement period under Section 1033(e)(2) applicable to all qualifying weather-related livestock sales - it is not a special automatic extension triggered only by a federal disaster declaration.
  13. Under Section 1033(g), when real property used in a trade or business is condemned, which of the following correctly describes the replacement period and qualifying replacement property standard?
    Answer: A 3-year replacement period; replacement property may be any like-kind real property held for productive use in a trade or business or for investment. Section 1033(g) provides a special rule for condemned real property used in a trade or business or held for investment: the replacement period is 3 years, and the qualifying replacement property standard is relaxed to allow any like-kind real property (mirroring the Section 1031 standard), rather than the narrower similar-or-related-in-service-or-use test. Answer A is wrong on both the period (2 years) and the property standard. Answer B correctly identifies the like-kind standard but states the wrong 2-year period. Answer C states the correct 3-year period but applies the more restrictive similar-or-related standard that does not apply to condemned real property under Section 1033(g).
  14. Packard Corp's delivery truck (adjusted basis $15,000, FMV $40,000) was stolen. Packard received insurance proceeds of $40,000 and purchased a replacement delivery truck for $40,000 within the replacement period. Packard elects Section 1033. What is Packard's basis in the replacement truck?
    Answer: $15,000 Realized gain = $40,000 - $15,000 = $25,000. Because replacement cost ($40,000) equals the proceeds ($40,000), all gain is deferred and recognized gain = $0. Deferred gain = $25,000. Basis of replacement truck = cost - deferred gain = $40,000 - $25,000 = $15,000. This equals the original adjusted basis of the converted truck, confirming that the deferred gain carries into the replacement property. Answer A ($40,000) is the cost with no deferred gain adjustment. Answer C ($25,000) is the amount of deferred gain, not the basis. Answer D ($30,000) has no basis in the Section 1033 formula.
  15. Ortega Corp received severance damages of $40,000 from a governmental authority that condemned an adjacent strip of land from Ortega's larger business parcel. No portion of Ortega's main parcel was condemned. What is the correct tax treatment of these severance damages?
    Answer: A reduction of the basis of the remaining property first, with gain recognized only to the extent damages exceed that basis. Severance damages received in connection with a partial condemnation are applied first to reduce the basis of the remaining property. Only if the severance damages exceed the remaining adjusted basis does the excess constitute gain. This reflects the principle that severance damages compensate for the diminution in value of the remaining parcel rather than constituting proceeds from a sale. Answer A is incorrect because severance damages are not inherently ordinary income. Answer C is incorrect because gain is recognized only if and to the extent the damages exceed remaining basis - they are not automatically fully taxable. Answer D is incorrect because amounts exceeding basis result in recognized gain and are not permanently excluded.
  16. Grantham Corp's factory was condemned by the state. Grantham received a condemnation award of $500,000. The factory's adjusted basis was $320,000. Grantham reinvested $480,000 in a replacement factory within the required period and elects Section 1033. How much gain must Grantham recognize?
    Answer: $20,000 Realized gain = $500,000 - $320,000 = $180,000. Under Section 1033, gain is recognized to the extent proceeds exceed the cost of qualifying replacement property: $500,000 - $480,000 = $20,000. Recognized gain is the lesser of realized gain ($180,000) or unspent proceeds ($20,000) = $20,000. Answer A ($0) would require reinvesting the full $500,000. Answer B ($160,000) is the difference between replacement cost and original basis, not the Section 1033 formula. Answer C ($40,000) doubles the correct figure without basis in the computation.
  17. A taxpayer elected Section 1033 nonrecognition after receiving condemnation proceeds but failed to purchase qualifying replacement property within the applicable replacement period. What is the tax consequence of this failure?
    Answer: The previously deferred gain becomes recognizable in the tax year the replacement period expires, and an amended return must be filed for the year of realization. If a taxpayer fails to purchase qualifying replacement property within the replacement period, any gain deferred under Section 1033 becomes recognized in the tax year the replacement period expires. The taxpayer must file an amended return for the year the gain was first realized and pay any resulting tax plus interest. Answer A is incorrect; there is no forfeiture of depreciation rights on future property. Answer C is incorrect because there is no automatic 6-month extension, though the IRS may grant an extension when a timely application is filed and circumstances warrant. Answer D is incorrect; the Section 1033 deferral is contingent on replacement, not permanent, and fails if replacement does not occur within the required period.
  18. Under Section 1033, when a taxpayer's replacement property costs more than the condemnation proceeds received, which of the following correctly describes the gain and basis treatment?
    Answer: The taxpayer recognizes no gain and the basis of the replacement property equals its cost reduced by the total realized gain. When replacement property costs more than the proceeds, the excess of proceeds over replacement cost is zero, so no gain is recognized. All realized gain is deferred. The basis of the replacement property = cost - total deferred gain = cost - total realized gain. For example, if proceeds = $100,000, original basis = $40,000, and replacement cost = $110,000: realized gain = $60,000; recognized gain = $0; deferred gain = $60,000; replacement basis = $110,000 - $60,000 = $50,000. Answer A is incorrect because no gain is recognized when reinvestment exceeds proceeds. Answer B is incorrect; FMV basis would apply only if gain were fully recognized, not deferred. Answer D is incorrect; gain is not measured against replacement FMV in the Section 1033 formula.
  19. A corporation's office building (adjusted basis $400,000, FMV $900,000) was condemned. The corporation received $900,000. To defer all realized gain under Section 1033(g), what is the minimum amount the corporation must reinvest in qualifying like-kind replacement real property within the 3-year period?
    Answer: $900,000 To defer all gain under Section 1033, the taxpayer must reinvest an amount at least equal to the full amount realized (the $900,000 condemnation proceeds). Any shortfall between proceeds and the reinvestment amount equals recognized gain. The realized gain is $500,000, but to defer 100% of it, the corporation must reinvest the full $900,000 of proceeds, not merely the gain amount. Answer A ($400,000) is only the adjusted basis of the converted property. Answer B ($500,000) is the realized gain, not the minimum reinvestment threshold. Answer C ($450,000) has no basis in the Section 1033 reinvestment requirement.
  20. Kelso Corp's plant was destroyed in a flood. Kelso received insurance proceeds of $800,000 against an adjusted basis of $500,000. Kelso purchased qualifying replacement property for $750,000 within the replacement period and elects Section 1033. How much gain does Kelso recognize?
    Answer: $50,000 Realized gain = $800,000 - $500,000 = $300,000. Under Section 1033, recognized gain equals the excess of proceeds over replacement property cost: $800,000 - $750,000 = $50,000. Answer A ($0) would require reinvesting at least the full $800,000 in proceeds. Answer B ($300,000) is the full realized gain and applies only if no replacement property is purchased. Answer D ($250,000) equals the difference between replacement cost and original basis, which is not the Section 1033 recognized gain formula.

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