Rev. Rul. 89-2

1989-1 C.B. 259, 1989-2 I.R.B. 4.

                       Internal Revenue Service

                                 Revenue Ruling

        INVOLUNTARY CONVERSIONS; DESTRUCTION BY CHEMICAL CONTAMINATION;

                            SUBSEQUENT CONDEMNATION

                           Published: January 9, 1989

SECTION 1033. - INVOLUNTARY CONVERSIONS, 26 CFR 1.1033(a)-1: Involuntary conversions: nonrecognition of gain

  Involuntary conversions; destruction by chemical contamination; subsequent condemnation. Property rendered unsafe for its intended use as a result of chemical contamination is destroyed for purposes of section 1033(a) of the Code. In addition, the subsequent sale of contaminated property to a governmental authority after the passage of an ordinance authorizing eminent domain proceedings constitutes a sale under threat of condemnation for purposes of section 1033(a) and (g) to the extent that the taxpayer can establish that the proceeds represent compensation for taking of the property by the government.

  An entity owned improved real property that it used in its trade or business. Through no fault of the property owner, dangerous chemicals were released into the property. A governmental agency determined that the property was contaminated in concentration levels greatly exceeding that deemed safe for habitation. The agency announced that businesses and residents should relocate. The government offered to buy the property from the property owner for an appraised value undiminished by the contamination. The government then passed an ordinance authorizing eminent domain proceedings, if necessary, to acquire the affected properties. The property owner accepted the government's offer and realized a gain on the sale.

  ISSUES. At issue is whether the chemical contamination, which rendered the property unsafe for the property owner's intended use, caused a property destruction for purposes of section 1033(a). Also at issue is whether the sale of the contaminated property to the government to protect the public health constitutes a sale under the 'threat of condemnation' for purposes of section 1033(a) and (g).

  HOLDINGS. The Service has held that the chemical contamination, which rendered the property unsafe for the property owner's intended use, caused a property destruction for purposes of section 1033(a). The Service also held that the sale of the contaminated property to the government to protect the public health constitutes a sale under the 'threat of condemnation,' only to the extent of the fair market value of the property, if any, after taking into account the diminution in value resulting from the contamination.

  ANALYSIS. Relying on C. G. Willis, Inc. v. Commissioner, 41 T.C. 468 (1964), aff'd per curiam, 342 F.2d 996 (3rd Cir. 1965), and Rev. Rul. 66-334, 1966-2 C.B. 302, the Service showed no hesitation in finding that the chemical contamination represented the 'destruction' of property for section 1033(a) purposes. The Service indicated that the key factors include the influence of an 'outside force or agency' beyond the property owner's control, and the uselessness of the property for its intended use.

  The Service then concentrated on the term 'condemnation' and the difference between (a) a property owner's compensation for the government's condemnation and seizure of his property and (b) a property owner's compensation for a loss resulting from the destructive force. Under section 1033, gain may be deferred on property destroyed and condemned by the government. Citing Rev. Rul. 74-206, 1974-1 C.B. 198, the Service concluded that the property owner at issue may claim the nonrecognition benefits of section 1033 only to the extent that the government's payment compensates for property condemnation, as opposed to property destruction.

ISSUES

  (1) If chemical contamination renders property unsafe for its intended use, is the property destroyed for purposes of section 1033(a) of the Internal Revenue Code?

  (2) Does the sale of the contaminated property to a governmental authority to protect the public health constitute a sale under the threat of condemnation for purposes of section 1033(a) and section 1033(g) of the Code?

FACTS

  The taxpayer owned improved real estate that it used in its trade or business in city X. Through no fault of the taxpayer, dangerous chemicals were released in the city where the taxpayer's property was located. After sampling the soil in the area, a governmental agency found widespread chemical contamination in concentration levels greatly exceeding the level that is deemed safe for habitation. Responsible health authorities determined that prolonged contact with the chemically contaminated soil represents a serious health risk. The health hazard caused by the chemical contamination is expected to continue indefinitely.

  Consequently, the governmental agency announced that the residents and businesses of the city should be relocated to protect the public health. Pursuant to an agreement among the federal, state, and city governments, all residents and businesses were asked to sell their contaminated property. The amount of compensation offered was based on the appraised value of the property undiminished by the contamination. City X also passed an ordinance authorizing eminent domain proceedings, if necessary, to acquire the affected properties. After passage of the ordinance, the taxpayer accepted an offer from city X to purchase its property. The taxpayer realized a gain from this sale.

LAW AND ANALYSIS

  Section 1033(a) of the Code provides for the nonrecognition of gain realized upon the involuntary conversion of property into money as a result of its destruction in whole or in part, or condemnation or threat or imminence thereof. Under section 1033(a)(2), if the taxpayer purchases other property similar or related in service or use to the converted property within a period generally ending 2 years after the first tax year in which gain is realized, then at the election of the taxpayer the gain is recognized only to the extent that the amount realized exceeds the cost of the replacement property.

  Involuntary conversion, within the meaning of section 1033(a) of the Code, means that the taxpayer's property, 'through some outside force or agency beyond his control, is no longer useful or available to him for his purposes.' C.G. Willis, Inc. v. Commissioner, 41 T.C. 468, 476 (1964), aff'd per curiam, 342 F.2d 996 (3d Cir. 1965). Not all involuntary conversions fall within the scope of section 1033; to qualify, a conversion must result from one of the specified causes. The Davis Co. v. Commissioner, 6 B.T.A. 281 (1927), acq., VI- 2 C.B. 2 (1927).

  Physical damage that renders property unfit for its intended use is a  'destruction' for purposes of section 1033(a) of the Code. Rev. Rul. 66-334, 1966-2 C.B. 302, concerns the gradual salt water contamination of an underground fresh water supply that was used for irrigation. The ruling holds that the contamination, which was caused by a fault in the earthen pit containing the salt water, is a destruction of property.

  In the present case, chemically contaminated soil in city X poses an irremediable hazard to human health. The taxpayer's property is essentially uninhabitable for the foreseeable future, and, consequently, is unfit for the taxpayer's intended use. Thus, the taxpayer's property is destroyed for purposes of section 1033(a) of the Code.

  For purposes of section 1033(a) of the Code, it does not matter whether the conversion stems from destruction, or the threat of condemnation, or both. To the extent that the conversion is attributable to the threat of condemnation, however, the taxpayer is eligible for the generally more liberal replacement requirements of section 1033(g).

  Section 1033(g)(1) of the Code provides that if real property held for productive use in trade or business or for investment is, as the result of condemnation or threat or imminence thereof, compulsorily or involuntarily converted, property of a like kind to be held either for productive use in trade or business or for investment shall be treated as property similar or related in service or use to the converted property for purposes of section 1033(a). Section 1033(g)(4) provides that in such a case the replacement period is determined by substituting '3 years' for '2 years.' Section 1.1033(g)-1(a) of the Income Tax Regulations provides explicitly that section 1033(g) does not apply to conversions attributable solely to destruction.

  As used in section 1033(a) and section 1033(g) of the Code, the term  'condemnation' refers to the process by which private property is taken for public use, without the consent of the property owner but upon the award and payment of just compensation. Rev. Rul. 57-314, 1957-2 C.B. 523. Public use includes a use intended to conserve the safety and health of the public, even though individual members of the public are unable to use the property taken. Normally, the measure of just compensation is the fair market value of the property taken by the government. See Uniform Eminent Domain Code section 1002 (1974).

  Although a taking to protect the health of the public may qualify as a condemnation under section 1033 of the Code, the taxpayer must distinguish proceeds that are attributable to condemnation (that is, to the government's action in taking the property) from proceeds that compensate the taxpayer for destruction. In Rev. Rul. 74-206, 1974-1 C.B. 198, the taxpayer's property, which had been damaged by a flood, was condemned under a state eminent domain statute that disregarded flood damage in determining fair market value for purposes of establishing the amount of the condemnation award. Reasoning that the statute was designed to provide both fair compensation for the property and a reimbursement for loss resulting from the flood damage, Rev. Rul. 74-206 concludes that the taxpayer's property was involuntarily converted in part as a result of condemnation and in part as a result of destruction.

  Here, city X purchased the taxpayer's property after passing an ordinance authorizing eminent domain proceedings. The passage of the ordinance satisfies the requirement that there be a threat of condemnation. Rev. Rul. 71-567, 1971- 2 C.B. 309. The amount paid by city X, however, was based on an appraised value that did not take into account the diminution in value caused by the chemical contamination. As in Rev. Rul. 74-206, the portion of the proceeds that compensates the taxpayer for the destruction of its property must be distinguished from the portion allocable to the condemnation. The proceeds are attributable to the condemnation only to the extent of the fair market value of the property, if any, after taking into account the contamination. The taxpayer may treat the portion of the gain attributable to compensation for the governmental taking under section 1033(a) or 1033(g) of the Code.

HOLDINGS

  (1) Property that is rendered unsafe for its intended use as a result of chemical contamination is destroyed for purposes of section 1033(a) of the Code.

  (2) In addition, for purposes of section 1033(a), which generally applies to all types of property, and for purposes of section 1033(g), which applies to real property held either for productive use in trade or business or for investment, if that property is sold to a governmental authority after the passage of an ordinance authorizing eminent domain proceedings to protect the public health, then the sale constitutes a sale under the threat of condemnation to the extent that the taxpayer can establish that the proceeds represent compensation for the taking of the property by the government, rather than compensation for the destruction caused by the contamination.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Karl T. Walli of the Office of Assistant Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling contact Mr. Walli on (202) 566-3297 (not a toll-free call).

Rev. Rul. 89-2, 1989-1 C.B. 259, 1989-2 I.R.B. 4.