So far this year, our office has had 3 clients have their property taken by a governmental agency through eminent domain proceedings. So, let’s briefly discuss some of the questions they should have asked and the information their financial and/or legal advisors hopefully gave them.
What options are available to me as the Taxpayer, when my investment real estate is involuntarily converted (taken from me)?
Answer: The Taxpayer has two major options.
- Use Section 1031 and transact a Tax Deferred Exchange.
- Use Section 1033 for tax deferral purposes.
What are the basic rules for a Section 1031 exchange?
Answer: There are 6 basic Rules on a Section 1031 Exchange:
- Both the property sold and the replacement property (the new property) must be held for use in a trade or business or have been held for investment purposes. IMPORTANT NOTE: the replacement property can be any type of investment real estate. So, you could sell a condominium unit and replace it with a piece of raw land, as long as they were both investment properties or used in a trade or business.
- The 45-day Rule for identification of a replacement property. The Taxpayer has up to 45 days from the day of closing to identify the property the Taxpayer may want to purchase.
- The 180-day Rule for the purchase of a replacement property. The Taxpayer has up to 180 days from the closing to close and purchase the replacement property.
- The taxpayer may not touch the funds from the sale of the relinquished property. As a result, the funds from the closing are given to an independent third party to handle the exchange portion of the transaction. That independent third party is called a Qualified Intermediary. Liberty 1031, LLC is a Qualified Intermediary. Liberty 1031, LLC is also responsible for preparing all of the 1031 documentation.
- The Same Taxpayer Rule. The Taxpayer of the relinquished property must be the purchaser of the replacement property. There are some possible variations to this rule. Be sure to discuss this item with your Qualified Intermediary and your Legal and/or Financial Advisor.
- Replacement Property Rule. In order to defer paying any taxes (Long Term Capital Gains, Depreciation Recapture Tax, and Possible State Taxes), the Taxpayer must purchase investment replacement property of equal value or more than the property that was relinquished (sold) and must reinvest all of the cash proceeds into the new replacement property.
What are the basic rules for a Section 1033 transaction?
Answer: There are 4 basic Rules on a Section 1033 taking:
- There is no requirement to hire a Qualified Intermediary.
- The property is involuntarily converted when one of the following events occurs: the property is destroyed by fire, earthquake, hurricane or some other destructive event, or the property is seized without governmental compensation (which makes this type of conversion somewhat irrelevant), or a governmental agency exercises its power of eminent domain or there appears to be an imminent threat of a requisition or condemnation (the property owner must be aware of the threat and must reasonably believe that condemnation is likely to happen).
- There is a partial conversion—occurs when a portion of the property is involuntarily converted. Note – If the taking of the real estate portion taken renders the operation of the business or use of the property economically impractical, then the Taxpayer could sell the whole property and defer taxes on the entire property when obtaining a replacement property.
- Timelines for a property held for productive use in a business or trade or for investment purposes. The Taxpayer has up to 3 years from the date the converted property was disposed of or the date of a threat or imminence of requisition or condemnation.
So which section should a Taxpayer use (1031 or 1033)?
Answer: A number of knowledgeable CPA’s have advised their clients to use BOTH sections. By using both Section 1031 and Section 1033, the Taxpayer would first use Section 1031, where the funds would be distributed to the Qualified Intermediary. The Taxpayer will then have 45 days from the closing of its relinquished property, to identify their possible replacement property(ies). The taxpayer also would have 180 days from the closing of the relinquished property to purchase a replacement property. The advantage of doing a Section 1031 tax-deferred exchange for the Taxpayer is that the replacement property can be any type of investment real estate. For example, a commercial piece of real estate can be exchanged for investment raw land. Should the Taxpayer fail to complete its 1031 exchange, then the escrowed funds would be distributed back to the Taxpayer. The Taxpayer could then continue with a Section 1033 Tax deferral to find and close on another property. BUT, under Section 1033, the replacement property must be very similar to or related in service or use, to the property that was taken, in order to have no gain recognized and not taxed.
One final comment: It is ALWAYS advisable that the Taxpayer speaks with their Legal and Financial counsel whenever dealing with an involuntary conversion. It is recommended that the information contained herein be saved for future use. Liberty 1031 LLC looks forward to working with you on future Section 1031 transactions.