The Internal Revenue Code provides that gain realized from a conversion is not recognized if the taxpayer receives qualifying replacement property, or if the taxpayer uses the conversion proceeds to purchase qualifying replacement property within a certain time.
Specifically, to have an involuntary conversion that results in complete or partial deferral of gain, the following conditions must be satisfied. First, the property must be compulsorily or involuntarily converted as a result of its destruction, theft, seizure, requisition, condemnation, or threat or imminence of requisition or condemnation. The term "destruction" is generally analogous to "casualty," but without the requirement that the loss be due to a sudden event. The destruction, however, must be beyond the taxpayer's control.
"Seizure" is probably best interpreted as "confiscation" generally by a governmental authority. "Requisition" or "condemnation" is the means by which a government acquires, without the owner's consent, private property for public use, in exchange for a reasonable compensation. A "threat or imminence of requisition or condemnation" exists when the taxpayer learns through a reliable source that a governmental authority has decided to acquire the taxpayer's property.
The second condition that must be satisfied is that the taxpayer must purchase qualified replacement property within a certain time period for the purpose of replacing the converted property. "Qualified replacement property" is property that is similar or related in service or use to the converted property. In determining "similar in use," the IRS has focused on whether there is "similarity in the relationship of the services or uses which the original and the replacement properties have to the taxpayer-owner." In addition to the "similar in use" standard, for real property that is held for use in a trade or business or for investment, qualifying replacement property can also be of "like-kind" to the converted property.
Deferral of gain is generally not allowed for replacement property acquired from a related person by a C corporation; by a partnership in which one or more C corporations own directly or indirectly more than 50% of the capital interest, or profits interest, in such partnership at the time of the involuntary conversion; or by any other taxpayer if, with respect to property which is involuntarily converted during the taxable year, the aggregate of the amount of realized gain on such property on which there is realized gain exceeds $100,000. However, a sale to a related person isn't covered by this rule to the extent that the related person acquired the replacement property from an unrelated person during the replacement period described below.
The qualified replacement property must be purchased within a two-year period, or for real property used in a trade or business or held for investment, within three years. The replacement period begins on the earlier of either (1) the disposition of the converted property, or (2) the threat or imminence of condemnation. The period ends two years (or three years for business or investment real property) after the close of the first taxable year in which any part of the gain on the conversion is realized.
Finally, the taxpayer must make a valid election to defer recognition of gain, unless the conversion is made directly into property similar or related in service or use to the converted property. The deferral is elected by including only the nondeferrable gain from the conversion on the taxpayer's income tax return for the year in which the gain is realized. All details connected to the conversion must be included on that return, including what replacement property.