Do severance damages count toward the award I must reinvest under section 1033?

Severance damages are paid for the land you keep, so they are tested against that land's basis

When an authority takes a strip for a road, a pipeline or a transit line, the parcel left behind is often worth less than it was: it has lost frontage, access, shape or a building that straddled the line. The payment for that loss is severance damages, and the tax treatment follows the economics. The Third Circuit in Vaira v. Commissioner held that such damages "are not included in calculating the amount received from the involuntary conversion" of the land taken and that the award "results in a reduction of the cost basis of the retained property", with the excess taxable.

The Second Circuit said the same in E. R. Hitchcock Co. v. United States: severance damages "go to reduce the cost basis of the taxpayer's remaining property", and "to the extent that that basis is exceeded there is a realized gain". Publication 544 adopts the same mechanics.

So the headline question has two answers. The award for the taken land is one involuntary conversion with its own basis and replacement target; the severance damages are a second conversion, of the land you still own, with a separate basis and target.

The arithmetic: two pots, two basis figures, two amounts to match

Hypothetically, you own ten acres of investment land with a $500,000 adjusted basis. The state takes two acres for an interchange and pays $400,000 for them plus $150,000 of severance damages for the eight acres left with worse access. Your CPA allocates $100,000 of basis to the two acres and $400,000 to the eight.

Pot one: the $400,000 award less $100,000 of basis is $300,000 of gain, deferred if replacement property costs at least the net award. Pot two: the $150,000 of severance damages reduces the basis of the eight acres from $400,000 to $250,000, and because the damages did not exceed that basis there is no gain in pot two and nothing to reinvest. Had the severance damages been $450,000 instead, $50,000 would be gain, and Publication 544 says you "can postpone reporting all your gain if the replacement property costs at least as much as your net severance damages".

Expenses are shared out before any of this. Publication 544 subtracts the costs of obtaining the damages from the gross figure, and where you cannot tell which expenses relate to which part of the proceeds "you must make a proportionate allocation". Check every allocation with your CPA, because the basis split between the taken and retained land drives both results.

• Award for the land taken: compare with the basis of that land; reinvest at least the net award.
• Severance damages: reduce the basis of the land kept; reinvest at least the excess over that basis, or restore the remainder.
• Expenses: match to each pot where you can, otherwise allocate pro rata.

Get the allocation in writing, because an unallocated award is treated as all for the land taken

Publication 544 is direct: "The contracting parties should agree on the specific amount of severance damages in writing." Hitchcock describes the consequence of not doing so: "if severance damages are not specifically set forth as a portion of the award", then "the entire award is compensation for the property taken". A lump sum with no breakdown is measured in full against the basis of the two acres, which usually produces more gain and a larger reinvestment target than the split would have.

Vaira shows the position is not absolute. There the award had no allocation, the IRS treated it all as general damages, and the court read that rule as having "created a rebuttable presumption that put the burden on the taxpayer". Testimony that the board of viewers had considered damage to the remaining land was enough to send the case back for a new trial on severance damages. Rebutting the presumption after the fact is expensive litigation; a sentence in the settlement agreement, carrying the appraiser's before-and-after figure for the remainder, is not.

Restoring the remainder counts as replacement for the severance gain

You do not have to buy anything to defer gain on severance damages. Publication 544 says that if you restore the remaining property to its former usefulness, "you can treat the cost of restoring the remaining part to its former usefulness as the cost of replacement property". Regrading, a new access road or relocated fencing can be the reinvestment, provided the spend restores rather than improves beyond the former state.

The alternative is to buy other property. The standard that purchase must meet, and whether the severance gain gets the like-kind rule and the three-year period that section 1033(g) gives condemned business or investment real property, was the subject of an IRS revenue ruling that could not be opened from a primary source for this page, so confirm that point with your tax counsel before relying on a purchase that is not similar in use. The replacement property rules and timeline page covers the standards in general.

Where the written split matters most

Farms losing road frontage, retail sites losing parking or a curb cut, and industrial parcels cut in two are the usual settings. Property taken by eminent domain looks at the whole decision for those owners, and reporting a condemnation under section 1033 explains how the two conversions appear on the return.

If part of the money ends up in a DST interest, the trust interest cannot be sold readily and its equity can be lost, and whether it qualifies as section 1033 replacement property for either pot is a question with no published authority; it should go to tax counsel rather than be assumed.