United States: Eminent Domain: Understanding The Tax Treatment Issues

Eminent domain is the process by which a government or entity has the ability to take private property for public use. Any property claimed through eminent domain must be fairly compensated. This triggers a process by which "fair compensation" is determined.  Once this process is complete, there will be an award to the owner of the property, based on "severance damages" for either loss in value of a larger parcel of property that was not acquired, or the value of the portion of the property that was taken.

For tax purposes, the proceeds from property acquired through eminent domain (or the receipt of an award) would be treated no differently from a sale of the property. Taxable gain (amount by which the proceeds exceed the tax basis of the property) results when a property is taken by condemnation (or sold under threat of eminent domain). Tax basis is determined as the original purchase price, less depreciation, plus any improvement costs. Taxable gain could be very large if long-term property or agricultural property was held.

If a property owner faces eminent domain, it is important to the review the situation, not only with an attorney, but also with a tax advisor. While it is likely that the award may be subject to taxation, any lien holder or lender may also have a claim to the awarded funds.  In most states, you may also have the option to reinvest the proceeds and defer the tax if you buy another property or real estate within a two-year time frame.

The Larger Parcel Concept

When a government takes land, it is not authorized to take more property than is actually required for its project. As a result, governments typically take land from a larger parcel, leaving the remainder of the property behind.

The term "larger parcel" signifies that the parcel taken by the government is not a complete parcel in itself, but part of a larger tract. For example, in a condemnation of a 100-foot-wide street right-of-way that runs through an 80-acre open space parcel, the 80-acre parcel would be the larger parcel; the parcel that would be negatively impacted in value by the taking.

The damages allowed on the severing of a parcel from a larger parcel recognizes that the grouping of separate parcels may produce a value greater than the sum of the individual parcels. The loss of one parcel, therefore, can reduce the value of the remaining parcels. The amount of damages is determined by a court based on the "highest and best value" of the larger parcel.

How to Identify the Larger Parcel

Even though details vary among states, a larger parcel generally must satisfy three tests:

  1. Unity of Use. This is the most important test and it requires the larger parcel to be put to a single, overall use. The unity of use determination is generally based on the property's highest and best use. Some relevant factors include: the current property uses; the time and expense necessary to terminate those uses; the current and proposed zoning for the parcels; the physical adaptability of the property for use as an integrated whole; the owner's development plans; the local regulatory climate; and local market conditions. As these factors suggest, the determination must take into account both the current state and its reasonably probable future uses. Current unity of use is not necessarily required, but courts will consider whether future unity of use is likely and the property is available for development as a single economic unit in the near future.
  2. Unity of Ownership. Unity of ownership requires that different parcels be owned by the same owner or set of owners. Courts may consider "equitable ownership" (a form of ownership not based on legal title, such as a right of use) to satisfy this test. Courts might also consider who controls the various ownership interests. For example, if one parcel is owned by an individual and the other is owned by an S corporation owned by that individual. Unity of ownership can exist even if the owner does not have the same quantity or quality of interest in each parcel, so a "fee simple" interest is not required.
  3. Contiguity. The contiguity test requires physical proximity between the parcels that form a larger parcel, which are likely to have similar highest and best use under a single owner. This test is generally considered the least critical. Property has been designated as larger parcels even when they are separated, as long as there is access between the parcels and a current or reasonably likely future unitary use.

"Larger Parcel" vs. "Assemblage"

The larger parcel concept is often confused with another concept known as assemblage. Assemblage deals with parcels that have different owners. For example, compensation for a parcel taken reflects the possibility that assemblage of the parcel with another parcel would have increased its value.

As explained by the U.S. Supreme Court, "The fact that the most profitable use of a parcel can be made only in combination with other lands does not necessarily exclude that use from consideration if the possibility of combination is reasonably sufficient to affect market value." In order to recover assemblage compensation, it must be shown that the parcels are likely to be developed in the future as an integrated unit and would result in the highest and best use of the property.

Understand What it Means to You

A government property claim under eminent domain is unpleasant enough without being aware of the tax consequences and the value of the compensation. Understanding how to evaluate the larger parcel affected by the taking can help you plan for the legal and tax issues associated with the receipt of a compensation award.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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