President and Chief Executive Officer
Exeter 1031 Exchange Services, LLC
This is my second article in a series of articles on Income Tax Strategies for Real Property. My first article provided a summary of the various tax deferred and tax exclusion strategies available to you when disposing of real estate.
My next few articles will delve deeper into the various tax strategies covered in my first article. I will then focus quite a bit of attention on the 1031 exchange, which is generally the better tax deferral solution in most situations. However, it is still important to be aware of the other tax deferred and tax exclusion solutions that are available in case your situation warrants another approach.
We also need to spend time discussing the various types of taxes that you might encounter when you dispose of real property. The taxes will depend on a number of things, but can include ordinary income taxes, depreciation recapture taxes, and capital gain taxes. I will explore these issues in much greater detail in a future article, so stay tuned.
Build and Maintain Wealth by Deferring Taxes
The ability to defer or exclude the payment of your taxes means that you can keep 100% of your equity (cash) working for you instead of paying it to the Federal and state governments.
This ability to keep your equity working for you by deferring your taxes is a critical component in any wealth building strategy, and makes a huge difference in the long run. It not only helps you build and accumulate wealth, but it also helps you maintain wealth.
1033 Exchanges (Involuntary Conversions)
This article addresses the basic planning issues involved with structuring and completing a 1033 exchange. The majority of advisors do not understand the nuances involved in a 1033 exchange, and there is very little guidance available, because 1033 exchanges are just not that common. However, we are beginning to see more and more of them.
Section 1033 of the Internal Revenue Code (“IRC”) applies to the disposition of real estate when the real property is the subject of an involuntary conversion. This type of tax deferred exchange is generally referred to as a 1033 exchange.
An involuntary conversion refers to the fact that the investor’s real property was taken from them or destroyed against their will either through an Eminent Domain proceeding (condemnation by the government) or a property loss due to a natural disaster such as an earthquake, hurricane, fire or flood, just to name a few.
Generally, the payments received from the government agency due to an Eminent Domain proceeding or the proceeds received from an insurance company due to a loss stemming from a natural disaster result in a taxable event of some type unless the transaction is structured correctly as a 1033 exchange.
Although it is never fun to go through an involuntary conversion, the 1033 exchange can provide the investor with some really nice tax planning opportunities, and, even though painful, can be a more favorable tax-deferred strategy than the 1031 exchange.
Opportunities Afforded by the 1033 Exchange
Here is a quick and concise overview of the 1033 exchange. It should be noted that although there are some similarities to the 1031 exchange and advisors frequently get the two confused, the 1033 exchange is quite different in its structuring and provides some great tax planning opportunities.
Holding Proceeds
There is absolutely no requirement to have the investor’s proceeds held by an independent third party such as a Qualified Intermediary like there is with the 1031 exchange.
The investor can receive, hold and use the proceeds received through a 1033 exchange with absolutely no tax consequences to the investor. This would be disastrous in a 1031 exchange, but not in a 1033 exchange.
Qualification
The investor will qualify for 1033 exchange treatment if the property is taken or destroyed, but he or she will also qualify if they have merely been threatened with an eminent domain proceeding. The investor would only have to prove that he or she was threatened in order to qualify for tax deferred treatment under Section 1033. It has to be an actual threat of an eminent domain action, and not just a hint or offer, but an actual threat that if the investor fails to sell the property to the government agency they will proceed with an eminent domain action.
Cashing Out
My favorite tax planning opportunity with a 1033 exchange is the ability to pull some or all of the cash equity out of the transaction without paying any taxes what-so-ever. Investors can actually pull cash out through the 1033 exchange. The proceeds do not have to be reinvested like they do in a 1031 exchange. Pulling cash out of a 1031 exchange will result in taxable boot, but not in a 1033 exchange. It’s a great way to free up trapped proceeds without having to pay taxes.
Trade Equal or Up in Value
The only reinvestment requirement is that the investor acquires replacement property or properties that have a fair market value equal to or greater than the property taken or lost through the involuntary conversion. It’s what we call trading equal or up in value. You can trade down and recognize some tax, which is referred to as a partial 1033 exchange.
Investors that have lost property through an eminent domain action will acquire other replacement property. Investors that have lost property to a natural disaster will generally structure a 1033 exchange by rebuilding the destroyed property, but could also reinvest by acquiring other replacement properties, too.
Like Kind Property
The definition of like-kind property under an eminent domain proceeding is essentially the same as under a 1031 exchange. The definition of like kind is a “similar or related in service or use” standard when involved with a natural disaster involuntary conversion.
Deadlines
The 1033 exchange also allows substantially more time to reinvest the proceeds into replacement properties. Investors generally have two (2) years under a natural disaster; three (3) years under an eminent domain proceeding; and four (4) years if it is their primary residence regardless of whether it was a natural disaster or eminent domain proceeding.
And, there you have it. A quick run down of the 1033 exchange.
Our next article will address the 1034 Exchange (repealed in 1997), which was replaced with the 121 exclusion. These tax codes generally apply to the sale of a primary residence, but there are some great tax planning opportunities available and there have been some recent changes that were contained in the 2008 Tax Act. Stay tuned...
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