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KELO, EMINENT DOMAIN, AND TAX BREAKS

January 30, 2006

Income tax rules might be a hidden snag in efforts to prevent municipalities from condemning property on behalf of private developers. Since the Supreme Court ruled last year in Kelo that such municpal condemnations are constitutional, efforts have sprung up to trim back such governmental powers.

The Des Moines Register printed a piece yesterday that pretty much said downtown Des Moines would be a tumbleweed-strewn wasteland without the ability of the city to condemn land for private purposes. The piece was run to oppose an anti-Kelo bill in the Iowa legislature.

SECTION 1033: TAX BREAK FOR THE CONDEMNED

It's unlikely that Principal or Wells-Fargo would have failed to assemble parcels needed for their new downtown buildings without the muscle of the City Council backing up their efforts. Yet the existence of a threat of condemnation carries tax breaks for sellers that probably enabled the property buyers to assemble their properties at a lower cost than they would have otherwise.

Section 1033 of the federal tax code allows sellers to avoid gain on property sold "under threat or imminence" of condemnation, as long as they re-invest the proceeds no more than two years after the year in which the sale is made. It's not necessary for the city to actually institute condemnation proceedings; just a credible threat triggers the tax break. The Tax Court has stated the rules so:

A “threat of condemnation” exists if (1) the body threatening condemnation possesses the power of eminent domain, (2) the property owner is told by an official of the threatening body that condemnation will be sought unless the owner negotiates a sale or exchange of the property, and (3) the information conveyed to the owner gives the owner reasonable grounds to believe that the threat was authorized and likely to be carried out unless a sale or exchange is arranged.…

A whiff of a threat of condemnation can make a sale tax-free to a buyer who is willing to reinvest in other property somewhere. A seller and buyer can more or less arrange a condemnation "threat" with the city to qualify a property for Section 1033. While I'm not privy to the Principal and Wells-Fargo land purchases cited by the Register, I would be surprised if Section 1033 wasn't an important part of the mix.

In theory, the buyers can arrange for similar tax results using a Section 1031 "like-kind exchange." These are more difficult to pull off, though, because there is only a six-month window to reinvest proceeds, and a Section 1031 deal has to meet a long list of fussy technical requirements.

I believe Kelo is bad law and bad policy (I include here my standard disclaimer that I speak for myself, not the firm). It still amounts to a way for the well-connected to get a better deal than the little guy in their property purchases. But efforts to overturn Kelo in the legislature may run into resistance from a surprising quarter: potential sellers of property who could use a whiff of condemnation to make their property sales tax-free.

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