Rev. Rul. 56-543

Advice has been requested whether an advance payment from the proceeds of an involuntary conversion to a contractor for the construction of property, which will be similar or related in service or use to the property converted, constitutes a purchase of replacement property.

During the year 1953, rental property owned by the taxpayer was destroyed by fire. By December 31, 1954, replacement was not completed but an extension of the replacement period was granted to December 31, 1955. During that period, the taxpayer made partial replacement expending two-thirds of the insurance proceeds in acquiring property similar to that involuntarily converted. He also entered into a contract with a builder to construct additional similar property and turned over to him the remaining amount of the insurance proceeds. The taxpayer did not insist that the structure be completed in 1955 and accepted various excuses from the contractor for his delay in beginning construction. In any event, completion could not have occurred and did not occur, in 1955.

Section 1033(a)(3) of the Code provides in part as follows:

(A) NONRECOGNITION OF GAIN.-If the taxpayer during the period specified in subparagraph (B), for the purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted, * * * at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion * * * exceeds the cost of such other property * * *.

The terms of section 1033 of the Code are very explicit in setting forth that a taxpayer is required to purchase replacement property within a prescribed time, with a privilege to apply for an extension of time for making the replacement. The fact that a contract is entered into with a builder to construct replacement property does not, on that basis alone, fulfill the requirements of section 1033 of the Code. The replacement must actually exist prior to the expiration of the period. Compare Rev. Rul. 55-517, C.B. 1955-2, 297. Accordingly, it is held that an advance payment from the proceeds from property involuntarily converted made to a contractor for construction of replacement property, where such property does not actually exist prior to the expiration of the replacement period, does not constitute the purchase of replacement property for the purposes of section 1033 of the Internal Revenue Code of 1954.