By Dwight Kay, CEO of Kay Properties and Investments and the Kay Properties Team
Understanding the rules of a 1033 Exchange aka Involuntary Conversion
DSTs provide replacement options for a property sold under eminent domain.
Property owners initiating a 1031 Exchange often end up in that situation by choice after deciding to sell an investment property or business. However, a 1033 Exchange is used when the government steps in to acquire a property by exercising its power of eminent domain.
What is Eminent Domain?
Eminent domain applies to situations where the federal, state or local government uses its authority to acquire private property for a public use or the greater good. Eminent domain has been around for decades with cases dating as far back as the late 1800s. It is commonly used by government entities to assemble land to build infrastructure, such as roads, interchanges or airport expansion. The government also has been known to step in and utilize its powers of eminent domain to acquire property to pave the way for private sector development that will in some way potentially serve the community or help raise the tax base, such as a new convention center hotel or a hospital. Eminent domain or condemnation also can come into play when a property has been destroyed by a natural disaster, such as flooding, hurricanes or wildfires.
Although eminent domain sounds a bit onerous, property owners are entitled to fair compensation for that property. Once that eminent domain transaction is complete, the question is what to do with that pile of cash? Just as with any property sale where the transaction generates a profit, any income recognized from that eminent domain acquisition is subject to capital gains tax. One way to potentially defer that tax bill is to roll the proceeds from the sale into a tax-deferred like-kind exchange. Whereas the 1031 Exchange is used for tax-deferred reinvestment in most property sales, eminent domain has its own separate category that falls under a 1033 Exchange.
What is a 1033 Exchange?
A 1033 Exchange is a property investment practice. This practice may allow you to avoid tax liability on capital gain from your forced loss of property due to eminent domain. The 1033 Exchange is a great way to get tax advantages when dealing with this type of property exchange. But it can be hard to know where to start. IRS 1033 exchange rules are tricky, and there’s a lot of misinformation out there that could cost you thousands in taxes.
You should know that if you do not follow the guidelines in section 1033 of the Internal Revenue Code, you may have to pay taxes on your capital gains and depreciation in the same year you receive your proceeds. It’s not uncommon for this to exceed 20-30% of your received proceeds. If you are experiencing a loss from forced conversion, this money should stay where it belongs, in your pocket
Many people who qualify for the 1033 exchange choose a “like-kind” replacement property. Simply put, “like-kind” means your investment real estate is exchanged for investment real estate. So, a personal residence or a vacation home—that is not primarily a rental property—will not qualify for a 1033 exchange. There are instances of investors choosing other options in addition to “like-kind” real estate, though they are much less common.
And, of course, the 1033 Exchange rules contain a specific criteria to meet: your property must fall under the eminent domain category. But, should you meet it, your 1033 Exchange has advantages over a 1031 Exchange. Before you decide, you’ll want to consider all of your options by comparing both.
Key differences and similarities in a 1031 vs 1033 Exchange
A 1031 Exchange and a 1033 Exchange were designed for exactly the same purpose. Both are sanctioned by the IRS as a means to defer capital gains taxes. However, there are some key differences that an owner should be aware of when conducting a 1033 Exchange. One notable item is that similar to a 1031 Exchange, a 1033 Exchange allows the taxpayer to fully defer both capital gains and any potential depreciation recapture taxes that may be incurred from the government acquisition. In other words, 1033 Exchanges have the potential for the taxpayer to avoid an even bigger tax bill. In addition, the IRS 1033 exchange rules are considered by many to be a bit more relaxed, giving property owners more time and flexibility to successfully execute the exchange. Some of those key differences are:
- More time to execute.The IRS 1033 exchange rules gives taxpayers two years from the date the sale closes to complete (three years if granted a further one-year extension) compared to 180 days for a 1031 Exchange.
- No limit on replacement IDs.The taxpayer has no restrictions on the number or dollar value of potential replacement properties they can identify for their exchange. In contrast, 1031 Exchanges have reporting rules that require that a limited number of replacement properties be identified within a 45-day window.
- No need for a qualified intermediary.In a 1033 Exchange, funds do not need to be handled by a qualified intermediary (also known as an Exchange Accommodator or Facilitator) as is the case with a 1031 Exchange. In fact, funds can even be placed into shorter-term investments, such as a bond or CD, until they are needed to close on the purchase of 1033 exchange replacement assets.
Do investors utilize DSTs for 1033 Exchange replacement property?
Yes, DSTS are commonly used in 1033 Exchanges. DSTs work just like other investment real estate, the difference being that it is fractional ownership. All of the same reasons why a DST work well for a 1031 Exchange also apply to cases of eminent domain where an owner is conducting a 1033 Exchange. For example, DSTs provide a solution that allows for portfolio diversification* and passive ownership in real estate as well as income potential.
Despite the longer timeline to complete a 1033 Exchange, the clock winds down quicker than many people realize. Some simply put off identifying replacement properties because they don’t know what to buy, or perhaps they are waiting out the market for better opportunities or pricing. So, it is not unusual for clients to focus on DSTs as replacement properties for their 1033 Exchange at the eleventh hour knowing they can reinvest proceeds in one or more DSTs in as little as a week’s time. For a free list of available DST investments for your 1033 Exchange please visit www.kpi1031.com
*Diversification does not guarantee profits or protect against losses.