J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

18.23 Types of Qualifying Replacement Property

Although exact duplication is not required, the replacement generally must be similar or related in service or use to the property that was involuntarily converted in order to defer tax. Where real property held for productive use in a business or for investment is converted through a condemnation or threat of condemnation, the replacement test is more liberal. A replacement merely has to be of a like kind to the converted property.

Under the like-kind test for condemned real estate, a replacement with other real estate qualifies. Improved real property may be replaced by unimproved real property (6.1). Foreign and U.S. real property are considered to be of like kind for purposes of replacing condemned property, even though under the like-kind exchange rules (6.1), U.S. real estate and foreign real estate are not considered like-kind property.

Under the related-service/use test, the replacement of unimproved land for improved land does not qualify. A replacement generally must be closely related in function to the destroyed property. For example, a condemned personal residence must be replaced with another personal residence. The replacement of a house rented to a tenant with a house used as a personal residence does not qualify for tax deferral; the new house is not being used for the same purpose as the condemned one. This functional test, however, is not strictly applied to conversions of rental property. Here, the role of the owner ...