Taxpayers may be forced to dispose of property as a result of circumstances beyond their control. If a taxpayer has a gain on an involuntary conversion of property, the taxpayer may elect to defer the gain if certain conditions are met. The conditions require that the property must be replaced and deferred gain will reduce the basis of the replacement property.

An involuntary conversion is the destruction of a taxpayer’s property in whole or in part, or loss of the property by theft, seizure, requisition, or condemnation. In addition, property sold pursuant to reclamation laws, and livestock destroyed by disease or drought, are subject to the involuntary conversion rules.

To defer the gain, the taxpayer must obtain replacement property that is “similar or related in service or use.” This definition is narrower than the like-kind rule; the property must be very similar to the property converted. Generally, a taxpayer has two years after the close of the tax year in which a gain was realized to obtain replacement property.

A realized gain on the involuntary conversion of property occurs when the insurance proceeds or other payments exceeds the taxpayer’s adjusted basis in the converted property. If a taxpayer does not reinvest the total amount of the payments received, a gain equal to the amount of the payment not reinvested (but limited to the gain realized) must be recognized. The basis of the replacement property is the cost of the replacement property reduced by any gain not recognized on the transaction. The holding period of the replacement property includes the period the original property was held.

The involuntary conversion provision applies only to gains, not to losses. The provision must be elected by the taxpayer. In contrast, the like-kind exchange provision discussed previously applies to both gains and losses and is not elective.

Involuntary conversions are discussed in Chapter 1 of Publication 544.