While real estate investing can offer the potential to increase personal net worth through passive income, it is important to note that no asset class doesn’t come without its own set of potential risks. Yes, there will always be a need for residential housing or commercial facilities, but there are still bumps in the road in the world of real estate investing. One such example is found in involuntary conversions, which can force investors to significantly alter their investment. Understanding what involuntary conversions are and the dangers they present is important when making informed decisions about your own investing.
What Is Involuntary Conversion?
Involuntary conversion is a term that is used when an investment property that you own in full or in part is stolen, condemned, destroyed, or disposed of under the threat of condemnation. Also referred to as involuntary exchanges, these conversions are complete when you, as the investor, receive some sort of compensation for the initial investment that was lost to one of the aforementioned issues. For instance, if your property is destroyed, you may receive some sort of financial compensation through insurance that you have purchased on the property. There are also condemnation awards that investors can collect if their investment property is condemned.
Examples of Involuntary Conversion
Since involuntary conversion is a diverse term, we will take a look at two examples of involuntary conversion and what it means for you.
In the first example, let’s say that you own an apartment complex. As the owner of a residential, income-generating property, you likely purchased insurance that protects you in the event that the property is damaged or destroyed. In this hypothetical situation, an electrical fire results in the total loss of your apartment complex. After investigation, your insurance company issues you a check for the amount of insurance that you have purchased on the property. Obviously, this check was not in your business plan, but due to the loss of the property, you receive an involuntary conversion of the property into a lump sum of money.
In another example, let’s say that a property that you’ve invested in suffers significant damage through a natural disaster such as a hurricane. Due to the damage suffered, the property that you’ve invested in is condemned. In many cases, the owner of a condemned property receives what is called a “condemnation award,” which is another form of payment that mitigates the loss of the subject property. Again, since you didn’t want a condemnation award and wanted to invest in the building, this is considered an involuntary conversion, as the property was converted to cash.
However, there are other instances where you may receive another property instead of cash. In those cases, it’s still considered involuntary, as you weren’t intending to invest in this secondary property.
What to Do If You Face Involuntary Conversion?
The most important aspect of legally handling an involuntary conversion is ensuring that you’re handling the tax implications correctly. Ultimately, what you choose to do with the money you receive or the new property that you get as a replacement is up to you. However, it’s important that you claim any capital gains or losses on your taxes for that year. Claiming losses can help you offset any gains you generated in other ways, while claiming capital gains is a requirement.
If you face an involuntary conversion, it’s important that you work with a tax professional who can help you take the legal path to claim your gains and losses. Involuntary conversions are certainly something to watch for, but they can be beneficial in some situations.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. All real estate investments have the potential to lose value during the life of the investment. You could receive back less than you initially invested and there is no guarantee that you will receive any income.