Navigating Tax Returns in North Carolina Eminent Domain Cases

Land condemnation is a daunting experience no commercial property owner wants or plans to face. Not only do they have to contend with losing their property rights and the uncertainty of their business, but they also need to navigate the complex tax implications of eminent domain proceedings.

According to the federal Internal Revenue Service (IRS) and North Carolina taxing authorities, eminent domain proceedings are a “taxable event” due to the sale or exchange of property. However, this does not always mean that taxes are owed. With tax season in full swing, here’s what you need to know about filing a return on eminent domain as a commercial property owner.

What is An Involuntary Conversion?

Involuntary conversion is the taking or destruction of property without an owner’s consent. A property can be considered involuntarily converted if any of the following events occur and you receive other property or money in payment, such as insurance or a condemnation award:

  1. The property is destroyed by a natural disaster, such as fire, earthquake, hurricane or any other destructive event;
  2. The property is stolen;
  3. The property is condemned; or
  4. The property is disposed of under the threat of condemnation.

According to the Internal Revenue Code (“the Code”), gain or loss from an involuntary conversion may be treated as a capital gain or ordinary income. Therefore, property owners may be subject to a capital gains tax for any proceeds received through an involuntary conversion and must report the gain or deduct the loss in the tax return for the year they were notified.

However, although compensation from land condemnation tends to be subject to taxation, property owners may have the opportunity to defer tax liability through a provision in Section 1033. Under Section 1033, property owners may qualify for a deferral of gains for tax purposes in the following scenarios:

  • The owner’s property is condemned, or there is a “threat of imminence” in condemnation
  • The owner replaces the condemned property within a specific timeframe (usually two or three years)
  • The replacement property is considered “eligible property” under Section 1033

If applicable, property owners can reinvest the proceeds into similar property and may defer paying taxes on the gains from the sale.

Understanding the Two-Year Rule for Involuntary Conversions

The IRS offers relief for property owners facing involuntary conversions through the two-year rule, also known as the involuntary conversion replacement rule. Under this provision, property owners have a two-year window from the end of the tax year in which the conversion occurred to replace the condemned property with similar property and defer recognizing any gain on the transaction. This deferral can help alleviate immediate tax liabilities and financially relieve affected property owners.

Taxes on Partial Takings

In some eminent domain cases, only a portion of the property is taken. This can complicate the taxation of the proceeds the property owner received. In these instances, a property owner needs to consider tax requirements for the (1) just compensation they received for the purchase of their property and (2) compensation they received for the loss of the value of their remaining land, known as damages to the remainder or severance damages.

Regarding the first issue, there may be a tax liability based on the property basis and other factors. For example, if the amount paid in “just compensation” is not more than what the landowner paid initially, then there is no taxable gain or tax liability. Regarding the second issue, tax liability is often deferred, assuming the landowner can adequately document the severance damages.

Do You Report Relocation Reimbursement on Taxes?

Property owners displaced due to eminent domain may receive relocation reimbursements to assist with moving and finding new housing. These reimbursements are generally not taxable if they are used for qualified expenses. However, any amount exceeding qualified expenses may be subject to taxation.

Can You Avoid Paying Taxes on Eminent Domain?

While it’s challenging to avoid paying taxes on eminent domain proceeds entirely, there are strategies to mitigate tax liabilities. These include understanding the rules surrounding involuntary conversions, seeking professional tax advice, and speaking with a reputable North Carolina eminent domain lawyer about your rights and options for deferring or minimizing tax obligations. 

Speak With Our Trusted North Carolina Eminent Domain Attorneys for Free

Navigating the taxation of eminent domain can further complicate an already confounding situation. Seeking guidance from experienced professionals is crucial. Our team of trusted North Carolina eminent domain attorneys at Henson Fuerst is here to help. We offer free consultations to property owners facing eminent domain proceedings, providing expert guidance and advocacy every step of the way.

Contact us by submitting a form below or calling our office at 919-781-1107 for a free consultation.