Rev. Rul. 83-39

ISSUE

Under section 1033 of the Internal Revenue Code, may a taxpayer that has elected nonrecognition of the gain realized from the involuntary conversion of property and has designated certain property as qualified replacement property substitute other qualified replacement property in its place?

FACTS

In 1978 the taxpayer realized a gain on the involuntary conversion of its propery. On its 1978 federal income tax return, the taxpayer elected to defer recognition of the gain under section 1033 of the Code.

Situation (1)

The taxpayer acquired qualified replacement property in 1979 and designated this property as the replacement property on its 1979 federal income tax return. The designation was made in a statement attached to the taxpayer's return. Before the replacement period expired, the taxpayer in 1980 acquired other replacement property and designated that property as the replacement property on its 1980 return. The taxpayer amended its 1979 return to delete the original designation.

Situation (2)

The taxpayer acquired replacement property in 1979 and designated that property as the replacement property on its 1979 federal income tax return. In 1980 it was determined that the property was not qualified replacement property. Before the replacement period expired, the taxpayer in 1980 acquired qualified replacement property and designated that property as the replacement property on its 1980 return. This designation was made in a statement attached to the taxpayer's 1980 return and explained the details in connection with the acquisition of the qualified replacement property in 1980. The taxpayer amended its 1979 return to delete the original designation.

LAW AND ANALYSIS

Section 1033(a)(2)(A) of the Code provides that if property is compulsorily or involuntarily converted into money, and the taxpayer during a specified replacement period, for the purpose of replacing the converted property, purchases other property similar or related in service or use to the converted property then, at the election of the taxpayer, gain will be recognized only to the extent that the amount realized on the conversion exceeds the cost of the replacement property.

Section 1.1033(a)-2(c)(2) of the Income Tax Regulations states:

All of the details in connection with an involuntary conversion of property at a gain (including those relating to the replacement of the converted property, or a decision not to replace, or the expiration of the period for replacement) shall be reported in the return for the taxable year or years in which any of such gain is realized. An election to have such gain recognized only to the extent provided in [section 1033(a)(2)(A) of the Code] shall be made by including such gain in gross income for such year or years only to such extent. If, at the time of filing such a return, the period within which the converted property must be replaced has expired, or if such an election is not desired, the gain should be included in gross income for such year or years in the regular manner. A failure to so include such gain in gross income in the regular manner shall be deemed to be an election by the taxpayer to have such gain recognized only to the extent provided in [section 1033(a)(2)(A)] even though the details in connection with the conversion are not reported in such return. If, after having made an election under section 1033(a)(2), the converted property is not replaced within the required period of time, or replacement is made at a cost lower than was anticipated at the time of the election, or a decision is made not to replace, the tax liability for the year or years for which the election was made shall be recomputed. Such recomputation should be in the form of an "amended return." * * * If the replacement of the converted property occurs in a year or years in which none of the gain on the conversion is realized, all of the details in connection with such replacement shall be reported in the return for such year or years.

Under section 1033(a)(2)(A) of the Code and section 1.1033(a)-2(c)(2) of the regulations the taxpayer must intend to replace the involuntarily converted property at the time of purchase of the qualifying replacement property. Consequently, the Code and regulations do not allow the taxpayer to decide at the end of the replacement period that a property purchased in an earlier year is to be used as qualified replacement property.

In McShain v. Commissioner, 65 T.C. 686 (1976), the United States Tax Court stated that section 1.1033(a)-2(c)(2) of the regulations sanctions only three circumstances under which recomputation of tax liability will be allowed: if the converted property is not replaced within the required period of time; the replacement is made at a cost lower than was anticipated at the time of the election; or a decision is made not to replace. The word "replace" as used in the regulations means replacement in fact. Therefore, the court concluded that if the taxpayer did, in fact, timely replace the converted property with similar property under an admitted plan of replacement before reaching a decision to revoke the taxpayer's earlier election, the taxpayer would be precluded from revoking the election because of a failure to fall within the qualifying circumstances set forth in the regulations.

Section 1.1033(a)-2(c)(2) of the regulations and the McShain case establish the finality of a section 1033 election when qualified replacement property is acquired during the replacement period. The finality is established not only for purposes of electing section 1033 of the Code treatment but also for purposes of choosing qualified replacement property. The purchase of replacement property that is not qualified replacement property, however, does not make a section 1033 election final.

HOLDINGS

In Situation (1), the taxpayer may not substitute other replacement property for qualified replacement property that the taxpayer had already acquired.

In Situation (2), the taxpayer may substitute qualified replacement property before the expiration of the applicable replacement period for the replacement property already acquired by the taxpayer, which was determined not to be qualified replacement property.