blog home Eminent Domain How Eminent Domain Can Affect Your Taxes in Los Angeles: What Property Owners Need to Know

How Eminent Domain Can Affect Your Taxes in Los Angeles: What Property Owners Need to Know

By Peterson Law Group on January 10, 2025

When the government takes private property in Los Angeles under eminent domain, the first thing most landowners focus on is compensation. But there’s another financial consequence that’s often overlooked until it’s too late: taxes.

Unlike a standard real estate sale, where you control the terms and timing, compensation from an eminent domain taking comes with unique tax implications. If not handled correctly, you could end up owing a significant amount in capital gains taxes or misreporting your settlement.

John S. Peterson is a Los Angeles eminent domain attorney at Peterson Law Group PC, where he helps property owners maximize their compensation and minimize tax liability during and after condemnation proceedings.

How Is Eminent Domain Compensation Taxed?

The IRS generally treats compensation from eminent domain as a sale of property. That means you may owe capital gains taxes on the difference between the amount received and your adjusted basis in the property (what you originally paid, plus improvements).

Land Compensation

This is the amount paid for the portion of the property being taken. If you own the property outright, this is subject to capital gains tax if it exceeds your basis.

Severance Damages

These are payments for the loss in value to the remaining property due to a partial taking. Severance damages are usually taxable as capital gains, unless rolled into a deferral strategy.

Relocation Assistance

If you’re required to move, you may receive compensation for relocation costs. This part may or may not be taxable, depending on how it is categorized.

• Payments for actual moving costs are generally not taxable.
• Payments above actual costs or treated as income can be fully taxable.

Here’s the bottom line: Each component of your settlement has its own eminent domain tax implications and should be reviewed carefully.

IRS Section 1033: The Key to Deferring Capital Gains

Fortunately, IRS Section 1033, offers a powerful tool to defer taxes on involuntary property sales. This rule allows you to defer capital gains tax if you reinvest the proceeds in a similar property within a specific time frame.

This is called an involuntary conversion, and it applies in eminent domain cases because the property is taken without the owner’s full consent.

Requirements for a Section 1033 Exchange:

• The property must be taken by a government entity or under threat of condemnation.
• You must reinvest in similar or related use property (e.g., from one commercial parcel to another commercial parcel).
• You typically have 2-3 years to complete the reinvestment.

Why use 1033 instead of a 1031 exchange? While 1031 exchanges (used in voluntary real estate transactions) require identifying a replacement property within 45 days and closing within 180 days, 1033 gives you much more time and doesn’t require a qualified intermediary.

When Are Severance Damages or Relocation Funds Taxable?

In partial takings, it’s common for the government to offer severance damages, which is compensation for the reduced value of the remaining property.

These payments are often taxable as capital gains, especially if they increase the overall payout beyond the basis of the entire property. However, if these funds are also reinvested under Section 1033 rules, you may be able to defer taxation.

Relocation funds are trickier. While federal law requires the government to assist with relocation, these payments can be structured in various ways. If not properly itemized or if you receive a lump sum, a portion may be treated as taxable income.

Timing and Classification of the Taking Matter

One of the biggest mistakes property owners make is not addressing tax consequences early enough. Timing and classification can significantly affect your liability.

For example:

• If you receive an advance payment but don’t reinvest quickly, you could trigger immediate taxation.
• If the property is classified as investment or business-use, you may be eligible for Section 1033 deferral.
• If the property is personal use (like a primary residence), capital gains exclusions under IRC Section 121 may apply instead.

Eminent Domain Compensation Tax Pitfall: Receiving a lump sum without proper planning could cause you to miss out on tax-saving opportunities.

Poor Guidance Can Cost You Thousands in Avoidable Taxes

Many property owners accept a government offer without realizing the hidden tax consequences. Worse, some attorneys, even real estate lawyers, lack experience with eminent domain-specific tax issues and miss key opportunities to protect your wealth.

Avoid these common tax mistakes:

• Failing to report severance damages correctly
• Missing deadlines for Section 1033 reinvestment
• Misclassifying property use
• Overlooking business or depreciation recapture tax
• Ignoring the opportunity to spread gains across tax years

How an Eminent Domain Attorney Can Help Protect Your Tax Position

At Peterson Law Group PC, we help you keep more of what you receive. That means building a tax-aware strategy from day one.

Here’s how we help:

• Evaluate whether you qualify for a Section 1033 exchange
• Separate compensation into taxable and non-taxable components
• Defend against aggressive government valuations that minimize your payout

When you’re facing a government land seizure, you’re not just losing property; you’re triggering a complex legal and tax event. We’re here to make sure you effectively manage your response with confidence.

Speak With a Trusted Los Angeles Eminent Domain Attorney

The government might owe you compensation, but the IRS could be standing right behind them with a bill. If you’re not proactive, taxes could take a painful bite out of your award. We’ll review your case, identify tax-saving opportunities, and fight for every dollar you deserve.

John S. Peterson was named Lawyer of the Year for Los Angeles by Best Lawyers for Eminent Domain and Condemnation Law. John has an AV Rating from Martindale-Hubbell®, and he’s a member of the Multi-Million Dollar Advocates Forum.

Call (213) 236-9720 to learn more about your options today.