October 18, 2023

Condemned to Lose Your ADIT?

IRS Rules Condemnation of Property a Disposition for Normalization Purposes
Holland & Knight Alert
Brad M. Seltzer | Mary Kate Nicholson


  • In a private letter ruling, the IRS concluded that a condemnation of public utility property is effectively a "retirement" or "disposition" that requires the elimination of Accumulated Deferred Income Taxes (ADIT) associated with the condemned property.
  • The IRS also concluded that the so-called "consistency rules" of Section 168(i)(9) of the Internal Revenue Code (Code) mandate that the removal of condemned public utility property from rate base also requires that the associated ADIT be eliminated.
  • The IRS had not previously ruled on the normalization consequences of a condemnation of public utility property under Section 1033 of the Code.

In a private letter ruling,1 the IRS concluded that the condemnation of public utility property is in effect a "retirement" or "disposition" that requires the elimination of accumulated deferred income taxes (ADIT) associated with the condemned property.

Addressing Condemned Property

The water and waste water treatment utility subject to rate regulation on a cost of service/rate of return basis had certain of its public utility property condemned by a local government. The taxpayer elected to defer the gain attributable to the condemnation of its facilities under Section 1033(a)(2) of the Code, reducing the basis of the replacement assets it acquired by the amount of the deferred gain under Section 1033(b). Following the condemnation, the companies became non-operating utilities, owned no operational assets or public utility property subject to cost of service/rate of return regulation, and served no customers.

In accordance with the Uniform System of Accounts, the taxpayer had recorded ADIT to reflect the method/life timing differences resulting from the use of accelerated depreciation (MACRS) for federal income tax purposes and the book depreciation method used for ratemaking purposes.2 The proper treatment of the ADIT under the normalization rules of Section 168(i)(9) upon the condemnation of the taxpayer's public utility property was the subject of a rate proceeding with the taxpayer's public commission (Commission). The Commission ordered the taxpayer to seek a private letter ruling to confirm or refute the author's testimony in that proceeding that the failure to eliminate the ADIT upon the condemnation would violate the normalization rules.

The IRS noted that under Treas. Reg. § 1.168-8, tax depreciation ceases when an asset is transferred or permanently withdrawn from service. For purposes of this rule, a disposition includes a sale, exchange, retirement, physical abandonment or destruction of an asset. The ruling concluded that the condemnation was such a disposition because it was the "functional equivalent" of a retirement. Accordingly, under Treas. Reg. §§ 1.168-(a)(8)(a), 168-8(b)(2) and 1.167(l)-1(h)(2), the ADIT associated with those retired former public utility assets must be eliminated.

In addition, under the so-called "consistency rules" of Section 168(i)(9), there must be consistent treatment of depreciation expense, tax expense, rate base and the reserve for deferred taxes for ratemaking purposes. Thus, when depreciation ceases upon the condemnation and the property is removed from rate base, the associated ADIT must be removed from the reserve for deferred taxes.


Holland & Knight Insight: The IRS distinguished the rules of Section 168(i)(7), which allow for the transfer of ADIT upon a disposition in "carryover basis" transactions such as those under Section 351 or Section 721 of the Code. However, these rules were inapplicable to condemnations because Section 1033 provides for a "substituted basis." It further noted that similar rules apply to unamortized investment tax credits related to deregulated property.

Although the IRS had not previously ruled on the normalization consequences of a condemnation of public utility property, in the private letter ruling it correctly concluded that the failure to eliminate the ADIT associated with condemned property subject to a Section 1033 election would violate the normalization rules.


1 The IRS has not yet publicly released the private letter ruling.

2 See Treas. Reg. § 1.167(l)-1(h)(2).

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.

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