One of the issues that California residents frequently face when discussing eminent domain is whether the payment a property owner or a business owner gets from the government is ordinary income, exempt from taxes, or treated as capital gains. In many cases, the answer depends on how the property holdings, what the seller intends to do with the money and whether the taxes are state or federal.
Eminent domain tax scenarios
When discussing how eminent domain payments are taxed, there are several scenarios to consider. For example, if the proceeds are for a vacation or a principal residence, the tax treatment is a long-term capital gain if the property gets held for more than one year. The same would apply if the property is used for investment purposes, as a business or for agriculture.
The situation changes slightly when discussing depreciable property like orchard trees or fences. In that case, eminent domain payments are considered ordinary income up to the extent of a recapture of prior depreciation.
Excluding or deferring
Depending on the duration of your occupancy, the Internal Revenue Code Section 121 allows you to potentially exclude up to $500,000 of gain for a principal residence (excluding vacation homes). If you receive eminent domain proceeds, you can defer tax under Code Section 1033 by purchasing replacement property for business or investment purposes or property that is similar in use to the condemned property within two years from the year of receiving the proceeds. Additionally, you have the option to request one or even two 1-year extensions from the IRS.
Learning the capital gains and income tax liabilities for eminent domain payments can be challenging. However, taking the time to understand them can save you heartache when it comes time to file your taxes.