Rev. Rul. 70-399

Advice has been requested whether, under the circumstances described below, the reinvestment of the proceeds from the involuntary conversion of a resort hotel is a conversion into property similar or related in service or use to the property converted within the meaning of section 1033(a)(3)(A) of the Internal Revenue Code of 1954.

The taxpayer owned a resort hotel which was leased to and operated by another taxpayer under a net lease agreement. In 1968, the resort hotel was destroyed by fire. In the same year the taxpayer used the insurance proceeds on the property destroyed to purchase another resort hotel. However, instead of leasing it to be operated by another, the taxpayer operated the hotel as the owner-operator.

Section 1033(a)(3)(A) of the Code provides, in pertinent part, that if property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted into money the taxpayer may elect not to have the gain recognized if, during the period specified, for the purpose of replacing the property so converted, the taxpayer purchases other property similar or related in use to the property converted.

In Revenue Ruling 64-237, C.B. 1964-2, 319, the Internal Revenue Service announced that, in considering whether replacement property acquired by an investor is similar or related in service or use to the converted property, attention will be directed primarily to the similarity in the relationship of the services or uses which the original and replacement properties have to the taxpayer-owner. In applying this test, a determination will be made whether the properties are of a similar service to the taxpayer, the nature of the business risks connected with the properties, and what such properties demand of the taxpayer in the way of management, services, and relations to his tenants.

In the instant case, the taxpayer was a lessor under a net lease which required nothing in the way of management or services given directly to the guests of the resort hotel immediately prior to its destruction by fire. Thus, as to the property destroyed, the taxpayer was holding the property for the production of passive rental income. However, as to the property acquired as replacement, the taxpayer is now involved on a day-to-day basis in the operation and production of income from the replacement property. Thus, the taxpayer is now in the business of running a hotel. In addition, there are substantial differences between the business risks of a net lease and owner-operation. Under a net lease, the lessor has a fixed return with none of the risks attendant to economic fluctuations and risks of liability to guests. As an operator of a hotel, the taxpayer has to deal directly with guests and bear the continuing burden of satisfying them.

In the instant case, the taxpayer, the owner-lessor of the property involuntarily converted, on becoming an owner-operator of the replacement property has so changed the nature of his relationship to the property as to be outside the nonrecognition of gain provisions of section 1033 of the Code.

Accordingly, it is held that, in the instant case, the replacement of the converted property is not a replacement of property similar or related in use to the property converted within the meaning of section 1033(a)(3)(A) of the Code. Any gain realized on the conversion is recognized for Federal income tax purposes.