You have been served.
When an investor receives a letter or notice from a government agency that the entity wants to “take your property” there is a variety of thoughts that go through your mind. There is a tax deferred section of the IRC that may be a life line or rescue to replace your property. IRC §1033 may be utilized in the case of replacing your property when taken by eminent domain or condemnation.
By Al DiNicola, AIF®, CEPA ™
May 8, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
1033 may also be utilized when your property is destroyed by a natural disaster. The 1033 may be the not so often used “cousin” to the 1031 tax deferred exchange. While there are similarities between 1031 and 1033 there are also differences to be addressed.
There is the ability to defer capital gains on real estate property used for business or investment purposes in both sections. The capital gains that may be due would differ depending on individual state of residency. Total capital gains tax may be 20% to 30% on the capital gains and potentially more depending on the state of residency. 1031 & 1033 are strategies that may temporarily mitigate taxes and offer alternatives.
The 45-day identification period and the 180-day closing period challenge investors to comply with the 1031. There is also the requirement to replace with like kind which has a broad interpretation. 1033 has a different set of rules which may be driven by the fact that the relinquishing of the investment property was outside the investor’s control. The property was either taken by a government entity or destroyed in a natural disaster.
Major benefits of the 1033 exchange
Potential access to a Cash Out option.
A few of the financial requirements in the 1031 exchange require the investor to reinvest all the cash and to replace the debt if there was a loan paid off. The other financial requirement is to replace the total value of the relinquished property. There are a few options in the 1033 exchange with the cash and debt components. Investors need only to match (or exceed) the total value of the relinquished property. The combination of cash and debt may be designed by the investor. Here is an example of a 1033 structure. The investor received proceeds from a condemnation of their property for building a new road. The total value of the property was $1,000,000 and the investor had a $300,000 loan on the property. The cash equity would be $700,000. The investor could purchase another property with a value of $1,000,000 and potentially obtain a loan of 60% ($600,000). This would require a cash equity component of $400,000. The remaining cash of $300,000 may be retained TAX FREE by the investor.
“Equal and Up Rule” Replacing Equity & Debt
- Equity in the replacement property must be equal to or greater than the net equity of the relinquished property. Equity cannot be replaced by additional debt.
- The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the relinquished property. Debt can be replaced with additional equity (cash).
- The cost of the replacement property must be equal to or greater than the net proceeds received. Equity can be replaced with additional debt.
- The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the property converted. Debt can be replaced with additional equity (cash).
Who needs a Qualified Intermediary?
Yes, you do if you are utilizing a 1031 exchange. Under IRC Section 1031 the investor may not take constructive receipt of any proceeds in a 1031. Taking constructive receipt (if even in an escrow account) would be subject to taxes on the capital gain. This is also considered “boot”. There is no requirement for an investor whose property was taken by eminent domain or destroyed by a natural disaster to utilize the services of a QI. What can an investor do with the money until the exchange is completed? The investor may invest the funds in a money market account, personal investment, or even the stock market. However, when the time comes to complete the exchange, the total value needs to be replaced.
Time is on your side.
We briefly reviewed the time constraints of the 1031 exchange. The flexibility of the 1033 exchange may give the investor a period of 2 to 3 years to complete their exchange. 1033 is considered a forced conversion. The other interesting requirement is there is no requirement to identify any specific replacement property and report to anyone. In the 1031 the 45-day identification list must be turned into the QI. This 1033 provision opens the door for the investor to identify almost any replacement property to finalize their purchase. The title is passed to the investor on the replacement property when the exchange is completed.
What to do with the cash?
There is the potential an investor may receive cash from two sources. The two sources may be when the government acquires your condemned property, or you receive the insurance proceeds on the destroyed property. Since you do not need a QI you can receive the cash. There is always the question of what do you do with cash? You are free to use or invest the proceeds in any vehicle you decide. Typically, a more conservative prudent investment would be suggested. The rationale would be you will need the proceeds to be reinvested to acquire the replacement property to complete the exchange. If your investment principal goes down (as in the stock market or risky investment) you will have less capital to complete the exchange. Remember the 1033 exchange requires the investor to match the entire value of the relinquished property in the replacement property.
Like Kind versus Like Kind versus Similar Use
The words “Like Kind” appear in both the 1031 and 1033 exchange requirements. However, there are differences between a 1031 and a 1033 exchange in the standard that is used to limit what you can buy as replacement property. In the 1033 exchange the replacement property must be “similar or related in service or use” to the property that was lost in the casualty or condemnation. This additional restriction is more restrictive than the like kind standard under IRC 1031. There is an alternative standard for replacement property, but only if the property is lost due to a condemnation and was held for productive use in a trade or business. In this case, the replacement property qualifies if it is “like-kind” to the converted property. Locating a replacement property that would be considered “like-kind” may be easier to comply with than the “similar or related in service or use” requirement. Bottom line if your office property was destroyed by a natural disaster then your replacement must be similar use (office). There is one other wrinkle with regards to replacement property. Under the 1033 you as an investor may purchase 80% control of a corporation that owns the replacement property. This would be rather than using the like kind for the exchange.
There are advantages and disadvantages with every investment opportunity. The 1033 tax deferred exchange is a tool investor need to understand. Having the right understanding can improve the overall positioning of the investor. The disadvantage may be the extended amount of time that investors have to make the decision on replacement properties. We have seen investors waiting for something “better” to come along. Occasionally having extra time may not be a positive and creates a relaxed feeling. All investments need to have the proper due diligence.
Accredited investors seeking replacement properties with a passive investment will seek out Delaware Statutory Trust (DST). The advantage with the DST structure affords the investor with non-recourse debt on the prepackage investment alternatives. Contact us for additional information on the DST structure and function for your potential investment solutions.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
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NAMCOA® – Naples Asset Management Company®, LLC