1033 Exchange/Eminent Domain Reinvestment
Eminent Domain / Forced Conversion
Sometimes property owners (taxpayers) may be subject to the involuntary or forced conversion of their property because of destruction, theft, requisition, or condemnation. These scenarios can all result in financial compensation to the property owner. This payment is taxable, however, IRC 1033 provides property owners the opportunity to defer the capital gains tax owed on their insurance payment, condemnation award, or other form of consideration for the forced conversion. In the case of forced conversions due to eminent domain, a property owner’s right to receive and negotiate compensation proceeds for their relinquished property is protected by the 5th Amendment.
The 1033 Exchange Solution
This conversion payment to the property owner is taxable in the year that it is received. This means that a tax liability is owed on the recaptured depreciation and capital gain of the property. The net, after-tax proceeds to a property owner after the tax liability is subtracted could be significantly less.
For this reason, property owners should consider the use of a 1033 exchange to defer the tax liability on their proceeds. The qualification guidelines to be eligible for a 1033 exchange are described by IRC 1033. Relinquished property proceeds are eligible for tax deferral if they are reinvested into a property that is equal or greater value and considered “like-kind” under IRC 1033 guidelines. Most investment real estate falls under the definition of “like-kind”, but IRC 1033 can be used as a guideline.
The first significant difference between 1031 exchanges and 1033 exchanges lies in the flexible timeline that 1033 exchanges benefit from. Starting from the earlier of the date property was destroyed or the date that threat of condemnation occurred, the owner has at least two years (in some scenarios three years) to close on a replacement property. In the meantime, the owner can hold the funds in their own account. So, unlike a 1031 exchange, a qualified intermediary is not required to successfully complete a 1033 exchange. It is important to note that investment losses during the holding period of the 1033 exchange cannot be used to offset the taxpayer’s requirement to reinvest into a property of equal or greater value. So, funds should be conservatively invested or remain in cash while searching for a 1033 replacement property.
The second significant difference between 1031 exchanges and 1033 exchanges is that equity in the relinquished property can be replaced by debt (this is not the case in a 1031 exchange). In other words, a taxpayer with $10 million conversion proceeds can purchase a qualifying $10 million replacement property at 80% loan-to-value and pocket $8 million cash.
Recommendations
Taxpayers should not wait until the 9th hour of their two-year window to find a suitable replacement property. We recommend that property owners are proactive in searching for suitable replacement properties to help them reach their financial goals.
As with any investment, there are risks associated with any investment into real estate. The list of risks is lengthy and property owners are encouraged to be comfortable with the risk of the investment that they choose. IRC 1033 guidelines are complex and we encourage all taxpayers to consult their tax/legal counsel before making an investment decision.
Sometimes property owners (taxpayers) may be subject to the involuntary or forced conversion of their property because of destruction, theft, requisition, or condemnation. These scenarios can all result in financial compensation to the property owner. This payment is taxable, however, IRC 1033 provides property owners the opportunity to defer the capital gains tax owed on their insurance payment, condemnation award, or other form of consideration for the forced conversion. In the case of forced conversions due to eminent domain, a property owner’s right to receive and negotiate compensation proceeds for their relinquished property is protected by the 5th Amendment.
The 1033 Exchange Solution
This conversion payment to the property owner is taxable in the year that it is received. This means that a tax liability is owed on the recaptured depreciation and capital gain of the property. The net, after-tax proceeds to a property owner after the tax liability is subtracted could be significantly less.
For this reason, property owners should consider the use of a 1033 exchange to defer the tax liability on their proceeds. The qualification guidelines to be eligible for a 1033 exchange are described by IRC 1033. Relinquished property proceeds are eligible for tax deferral if they are reinvested into a property that is equal or greater value and considered “like-kind” under IRC 1033 guidelines. Most investment real estate falls under the definition of “like-kind”, but IRC 1033 can be used as a guideline.
The first significant difference between 1031 exchanges and 1033 exchanges lies in the flexible timeline that 1033 exchanges benefit from. Starting from the earlier of the date property was destroyed or the date that threat of condemnation occurred, the owner has at least two years (in some scenarios three years) to close on a replacement property. In the meantime, the owner can hold the funds in their own account. So, unlike a 1031 exchange, a qualified intermediary is not required to successfully complete a 1033 exchange. It is important to note that investment losses during the holding period of the 1033 exchange cannot be used to offset the taxpayer’s requirement to reinvest into a property of equal or greater value. So, funds should be conservatively invested or remain in cash while searching for a 1033 replacement property.
The second significant difference between 1031 exchanges and 1033 exchanges is that equity in the relinquished property can be replaced by debt (this is not the case in a 1031 exchange). In other words, a taxpayer with $10 million conversion proceeds can purchase a qualifying $10 million replacement property at 80% loan-to-value and pocket $8 million cash.
Recommendations
Taxpayers should not wait until the 9th hour of their two-year window to find a suitable replacement property. We recommend that property owners are proactive in searching for suitable replacement properties to help them reach their financial goals.
As with any investment, there are risks associated with any investment into real estate. The list of risks is lengthy and property owners are encouraged to be comfortable with the risk of the investment that they choose. IRC 1033 guidelines are complex and we encourage all taxpayers to consult their tax/legal counsel before making an investment decision.