One bright, sunny day you might hear a knock on the door. When you answer it, the local mail man hands you a certified letter, requiring your signature. You sign, take the letter and rip it open.
Inside is a notice that your city wants to build a massive public park. The city is claiming all property in the area as part of the project—including the rental property you own and operate. The letter also tells you how much it will pay you to seize that property.
This is an example of eminent domain. And there will be a lot going through your mind with that notice. What you might not be thinking, however, is whether the money you receive from eminent domain is taxable. But it’s an important issue to consider.
First of all, what is eminent domain? Through eminent domain, the United States government, states, and municipalities have the power to take private property for public use. This is known as “taking,” and you, as the property owner, don’t have much say in stopping such a seizure. You don’t have to give permission for the government to seize your land.
But you are entitled to compensation for that taking. The Fifth Amendment of the United States Constitution guarantees that if the government seizes your property for public use, it’s required to do so only after paying you “just compensation.” Such compensation is based on the property’s assessed fair market value.
Meanwhile, “public use” is defined as something that will increase the welfare of the general public. Additionally, “property” isn’t limited to real estate under the eminent domain definition. It can also include easements, personal property, and even trade secrets.
So, you’ll be compensated through the eminent domain process. But is that compensation taxable?
Yes. Because of the way eminent domain is structured, the IRS considers the payment you receive in return for turning over your property an actual sale. And similar to that actual sale, any gain you receive from it is taxable. That is, as long as what you receive is greater than the property’s current taxable basis. In other words, greater than what you paid for the property, plus any capital improvements, taxes, fees or other costs.
So, according to the IRS, you lose ownership rights. And when tax time comes around, you’ll receive a Form 1099-S – “Investment Sale” – to file.
Eminent domain seizure can’t be avoided, unless you’re willing and able to embark on a legal battle to prove that the taking has nothing to do with public welfare.
Taxes on eminent domain compensation also can’t be avoided. However, 26 U.S. Code § 1033, “Involuntary Conversions,” does provide some ways in which eminent domain gain taxes might be deferred.
But the overall rule of thumb is that any compensation from a property taken through eminent domain will be taxed. If you have any questions about this issue and your responsibilities, it’s a good idea to talk with a tax attorney or your accountant.