Individual Case

Individual Case 1
Facts:
Mame Green is the owner and operator of the sole proprietorship Green Haven hotel in St. Simons, Georgia. At the beginning of the 2015 tax year, the hotel had a fair market value of $3,000,000 and an adjusted basis of $1,500,000, the hotel furniture and other furnishings had a fair market value of $1,000,000 and an adjusted basis of $100,000, and the hotel had a fair market value of $5,000,000 and an adjusted basis of $3,000,000. Three months ago, Green Haven was completely destroyed by a fair. Green Haven was covered under a fire insurance policy, and as a result, Mame received $4,000,000 after settling the claim. $3,000,000 was allocated to the building and $1,000,000 for the loss of furniture and equipment. Using the $4,000,000, Mame plans to use $3,150,000 to build a smaller hotel on the same land Green Haven was located and $350,000 to purchase hotel furniture and furnishings. Mame plans to use the remaining $500,000 from the proceeds to invest in undeveloped beach property on the other side of the island. The hotel is expected to be completed in 2 ½ years.
Issue:
1. Does Mame have to recognize any gain on his $500,000 purchase on undeveloped beach property, and if so, what will the character be?

2. Will Mame have to recognize any gain on the construction of the hotel building or purchase of the replacement furniture and furnshings?
Authorities
Issue 1
IRC Sec. 1033(a)(2)(A) IRC Sec. 1231(a)(3)(A)(ii) Rev. Rul. 64-237, 1964-2 CB 319.
Issue 2 IRC Sec. 1033(a)(2)(A), (B), (g)(4) Reg. Sec. 1.1033(a)-2(c) Massillon-Cleveland-Akron Sign Company v. Commissioner, 15 T.C. 79 (1950). Rev. Rul. 70-501, 1970-2 CB 163.
Conclusion
1. In applying the “functional test” the undeveloped beach property does not qualify as replacement property, so Mame will have to recognize $500,000 of 1231 gain on this transactions. 2. The construction of the hotel and purchase of furniture and furnishings qualify as replacement property for the hotel building as a whole that was involuntarily converted, so Mame will be able to delay recognition of any gain realized.
Analysis
1. Does Mame have to recognize any gain on his $500,000 purchase on undeveloped beach property, and if so, what will the character be?
The total destruction of the hotel and furniture and furnishings that if property as a result of destruction is converted into money, the taxpayer will be allowed to delay recognition of any gain so long as the purchased property is “similar or related in service or use to the property so converted”. The question now becomes whether undeveloped beach property is similar or related in service or use to a hotel building. Revenue Ruling 64-237 attempts to address this issue. In this Revenue Ruling, the IRS states they have taken the phrase “similar or related in service or use” to mean that property has close functional similarity. This “functional test” means that physical characteristics and end users of converted and replacement properties are similar. While the IRS doesn’t apply this “functional test” if the taxpayer is a lessor, they will still apply it for owner taxpayers which applies here. Looking at the client’s case, he was previously an owner/operator of the hotel building and his role in the undeveloped beach property is solely that of an owner. Also, the physical characteristics and end users have changed as the involuntarily converted property was a developed building used in the client’s primary trade or business of hospitality while this beach property is at this time just investment property in the form of land. Therefore in applying the “functional test”, this undeveloped beach property will not qualify as replacement property for the involuntarily converted hotel, so the client will have to recognize a gain on the $500,000.
As for the character of the gain, Section 1231(a)(3)(A)(ii) states that any recognized gain from involuntary conversions qualifies as a Section 1231 gain. Thus, the client will recognize $500,000 of 1231 gain (capital gain). 2. Will Mame recognize any gain on the $500,000 spent on the purchase of undeveloped land, and if so, what character will the gain be?
Likewise in analyzing the tax effects of the purchase of the new furniture and furnishings and the construction of the new hotel, the transaction will also fall under Section 1033(a)(2)(A) of involuntary conversions. This time, the hotel and furniture and furnishings will meet the “functional test” as these properties will have the same physical characteristics and end users. Another requirement falls under Section 1033(a)(2)(B) which states that the property must be replaced within the 2 years. While the hotel is set to be finished in 2 ½ years, it will still qualify as replacement property because Section 1033(g)(4) specifically states that converted property used in trade or property will be allowed 3 years to be replaced. Therefore, the hotel and furniture and furnishings will still be applicable as it falls under this time frame.

The next thing to determine is any gain or loss effects of purchasing the replacement property. There appears to be a net gain if applying the insurance proceeds (excluding the $500,000 for the beach property) in aggregate to the purchases. However, Revenue Ruling 70-501 states that insurance proceeds of a single insurance policy do not need to be considered as a unit. In this Revenue Ruling, the taxpayer received a lump-sum of insurance proceeds for the destruction of both the building and machinery and equipment within. Like in our client’s situation, the taxpayer had one class of property experience a gain and another experience a loss. The IRS ruled that the taxpayer would still be allowed to delay recognition of the gain realized.

In Massilon-Cleveland-Akron Sign Co. v. Commissioner¸ the taxpayer also received a lump sum from the insurance company for both a building and machinery in a manufacturing that was destroyed in a fire. The taxpayer received roughly $61,000 for the destruction of the building and $39,000 for the destruction of the machinery. In purchasing replacement property, the taxpayer spent $80,000 for the reparation of the building and only $20,000 for the machinery. The IRS tried to rule that excess of proceeds over cost of replacement for the machinery was not used in the acquisition of similar property since it was put towards the replacement of the building. The Tax Court held that the IRS was erroneous in their judgment and the approximately $100,000 lump sum was used to replace the assets of the manufacturing plant and that proceeds did not need to be specifically earmarked to replace the building and others for the machinery.

In applying the case law and Revenue Ruling, the client similarly receives a lump-sum of proceeds under a presumed single policy, and while $3,000,000 was allocated to the building and $1,000,000 to furniture and furnishings, the client need not necessarily repair the property in that specific portion. Thus, the client will be able to delay recognition of the gain they would realize on the $3,500,000 that they spent on the construction of the new hotel and the purchase of new furniture and furnishings.