REV-RUL, Involuntary conversion; replacement by lessor; commercial building for farmland., Rev. Rul. 76-391, 1976-2 CB 243, (Jan. 01, 1976)
Rev. Rul. 76-391, 1976-2 CB 243

Section 1033.--Involuntary Conversions

26 CFR 1.1033(a)-2:  Involuntary conversion where disposition of the converted property occurred after December 31, 1950.
(Also Section 1.1033(g)-1.)

[IRS Headnote] Involuntary conversion; replacement by lessor; commercial building for farmland.-- 
A commercial building, to be held for rental on a net-lease basis, built on land owned by the taxpayer with the proceeds from the involuntary conversion of unimproved farmland leased for many years to tenant farmers will not qualify as property similar or related in service or use or as like kind property under the nonrecognition-of-gain provisions of section 1033 of the Code.

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Advice has been requested whether the nonrecognition-of-gain provisions of section 1033 of the Internal Revenue Code of 1954 are applicable under the circumstances described below.

Under a threat of condemnation, the taxpayer sold 50x acres of its farmland to a municipality.  The farmland, which was not improved with buildings such as a farm house or a barn, had been leased by the taxpayer to tenant farmers continuously since 1950.  The sale constituted an involuntary conversion of real property held for productive use in a trade or business or for investment within the meaning of section 1033 of the Code.  The proceeds from the sale were used to construct a commercial building on other land already owned by the taxpayer.

The building is suitable for leasing as five separate units, the interior of which are not finished.  Parking facilities surrounding the building have been provided.  It is anticipated that the taxpayer will perform no interior or exterior maintenance on the building structure because the building will be leased on a net-lease basis.  However, the taxpayer will be responsible for the parking lot and will have to make physical changes to the building to accommodate new tenants.  The taxpayer will also be responsible for maintenance when vacancies occur.  Electricity, telephone service, and water will be provided to the building and individually charged to the tenants by the utility companies involved.  The real property taxes upon the subject property will be paid by the taxpayer and reimbursed by the tenants on a pro rata basis.  All taxes or personal property of the tenants will be paid by the tenants.  The insurance coverage will be added to the taxpayer’s existing insurance policy coverage and the cost thereof reimbursed by the tenants on a pro rata basis.

Specifically, the question presented is whether a commercial building, to be held for rental, that was constructed upon property owned by the taxpayer is “property similar or related in service or use” to the converted farmland, within the meaning of section 1033(a) of the Code.

Section 1033(a)(3)(A) of the Code provides, in part, that if property is compulsorily or involuntarily converted into money and the taxpayer, during the period specified, purchases other property similar or related in service or use to the property so converted, then at the election of the taxpayer, gain shall be recognized only to the extent that the amount realized upon such conversion exceeds the cost of such other property.

Rev. Rul. 64-237, 1964-2 C.B. 319, states that in considering whether replacement property acquired by an investor is similar in service or use to the converted property, attention will be directed primarily to the similarity in the relationship of the services or uses that the original and replacement properties have to the taxpayer-owner.  In applying this test, a determination will be made as to whether the properties are of a similar service to the taxpayer, the nature of the business risks connected with the properties, and what the properties demand of the taxpayer in the way of management, services, and relations to its tenants.  See also Liant Record, Inc. v. Commissioner, 303 F.2d 326 (2d Cir. 1962).

In the instant case, the taxpayer constructed a commercial building dependent upon the needs of prospective tenants.  Although the taxpayer intends to lease the building on a net-lease basis, it will be responsible for its maintenance when vacancies occur.  In addition, the taxpayer will be responsible for the maintenance of a parking lot and will be required to make physical changes in the building to accommodate new tenants.  On the other hand, the farmland that had been leased by the taxpayer to the tenant farmers required no maintenance.

Accordingly, under the test enunciated in Rev. Rul. 64-237, a commercial or industrial building to be held for lease does not qualify as property similar or related in service or use to leased farmland within the meaning of section 1033(a) of the Code.

Section 1033(g) of the Code provides, in part, that if real property held for productive use in trade or business or for investment is, as the result of its sale under threat of condemnation, compulsorily or involuntarily converted, then 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 property so converted for purposes of section 1033(a).

Rev. Rul. 67-255, 1967-2 C.B. 270, states that the effect of section 1033(g) of the Code is to extend the nonrecognition-of-gains benefits of section 1033(a) to a taxpayer who acquires property of a like kind to real property converted, but not necessarily similar or related in service or use to the converted property.  Rev. Rul. 67-255 holds that an office building, to be held for investment purposes, that was constructed upon land already owned by the taxpayer does not qualify as being of a like kind to the land that was involuntarily converted.  Although the term “real estate” is often used to describe both land and improvements on the land, land and improvements are by nature not alike merely because one term is used to describe both.  Land is not of the same nature or character as a building.

In accordance with Rev. Rul. 67-255, the commercial building, to be held for lease, that was constructed upon land owned by the taxpayer does not qualify as a like-kind replacement of its leased farmland within the meaning of section 1033(g) of the Code.

Therefore, the nonrecognition-of-gain provisions of section 1033 of the Code are not applicable in the instant case because neither the test enunciated in Rev. Rul. 64-237 nor the “like kind” test of section 1033(g) have been satisfied.