A 1031 exchange is an excellent tool to use to defer taxes indefinitely that might otherwise be due on the sale of investment property. Similarly, there is also tax relief available to investors when their property is acquired by a governmental authority or destroyed. The rules governing these events are covered under Section 1033 of the Internal Revenue Code. Both Section 1031 and Section 1033 allow gain and the related tax to be rolled forward into like-kind replacement property as long as the taxpayer complies with certain provisions. The technical tax and legal term used to describe both destruction of property and property taken by the government is “involuntary conversion”. When a governmental authority takes property from an owner, it does so by the powers of eminent domain, which is essentially a compulsory purchase or condemnation.
While there are similarities in the rules of Sections 1031 and 1033, there are many differences; lesser differences also can be found between property taken by eminent domain and property that is destroyed. Property taken by eminent domain is the most common. This term defines situations in which a government authority exercises its right to take property that it wants to use from the owner, whether or not the owner wishes to sell. The most common uses of property taken by eminent domain are for government buildings and other facilities, public utilities, highways, and railroads. In what may be better described as a “forced purchase”, the governing authority must first compensate the owner for the fair market value of the property. Despite the terminology, in practice, this is usually a friendly transaction that begins when the government authority contacts the owner of the property letting them know their interest in purchasing it. The next step is for appraisals to be done and moves forward when both the owner and the authority agree on a price. (If they can’t agree on price, the owner does have the right to appeal to a court of law to determine the fair market value.)
An owner who sells a property to a governing authority in this way may be facing a taxable gain that they would like to defer. In an “eminent domain” Section 1033, the “like-kind” definition of the replacement property is the same as the definition under Section 1031: “property held for productive use in a trade or business or for investment.” Also similarly, the property acquired must be the same price or greater than the property that was taken. But unlike a Section 1031, there is no requirement to replace the cash proceeds and the debt relieved that may have been relieved in the sale. Therefore, the taxpayer can choose to use just a portion of the proceeds when they acquire new property. In other differences, the transaction must be completed within 3+ years; there is also no need for qualified intermediary or accommodator services. At the sale, the taxpayer can deposit the proceeds in their own bank account without any restrictions on the use of these funds. But, to have no tax consequences, they must buy the replacement property within the stipulated time frame.
For example, the city of Atlanta contacts the owner of an investment property that the city needs to acquire in order to expand a well-traveled roadway. After an appraisal, the city and the owner agree to an $2,800,000 price for the property that is currently unencumbered by debt. In order to best document his situation, the owner asks for and receives a “threat of condemnation letter” from the city that states that the city intends to take the property either through a friendly agreement or through its powers of eminent domain. The owner sells the property to the city on September 1, 2022 and receives $2,800,000.
The time frame that the owner has to replace the property begins at the end of the tax year in which it is sold and extends a full three years further. So, in this example, the owner would have until December 31, 2025 to complete the replacement acquisition. As long as the replacement property costs $2,800,000 or more, and is acquired by that date, the owner will have complied with the 1033 rules.
An involuntary conversion under Section 1033 occurs when a taxpayer’s property is destroyed due to fire, water or wind. If the property is insured, then the date that the owner receives the insurance proceeds is considered the “relinquished sale date”. Unlike the requirements of a Section 1031 or property taken by eminent domain under a Section 1033, the replacement property that the owner acquires or rebuilds must be “similar in use or service” as the property destroyed. While there are debates about what “similar in use or service” means, it is generally agreed for example, that if the property destroyed was an income-producing property, then the acquisition of undeveloped land would not meet the definition. In this instance, the taxpayer has 2+ years to acquire or rebuild the replacement property.
For example, a taxpayer owns a hotel free and clear that destroyed in a storm. Thankfully, the property was insured for $2 million which the owner receives from the insurance company on August 1, 2022. To calculate the stipulated replacement time frame, you begin at the end of the current tax year (December 31, 2022) and add two additional years. Therefore, in order to comply with the 1033 guidelines, the taxpayer would have until December 31, 2024, to complete any rebuilding or purchase a property that is “similar in use or service”. Like the eminent domain rules, the taxpayer does not have to use a qualified intermediary or accommodator and can take direct control and possession of the insurance proceeds. The owner just needs to rebuild or purchase a replacement property that is the same value or greater than that which was destroyed. For example, if the taxpayer elects to buy a $2 million hotel to replace the one destroyed, he can use $500,000 of the insurance proceeds, obtain a $1.5 million loan for the difference, and spend the remaining $1.5 million in insurance proceeds as he or she likes.
While the Section 1033 rules are much more liberal than those under Section 1031, there are some additional restrictions that deserve mentioning. The taxpayer cannot buy the replacement property from a related party, and tax penalties can be assessed if the replacement property is not acquired or replaced in the stipulated time frame. Extensions of the replacement time frames can be requested and granted. It is important to note that there can be additional complexities to transactions in which the governmental authority acquiring the property stages payments to the owner or if pieces of the property are acquired over a longer time period. In any of these situations, it is important to consult your tax professional before going forward with this type of transaction. Click here to see our video on 1033 exchanges. Feel free to contact us if you have questions or would like more information.
