A 1031/1033 exchange is a highly technical financial transaction. While many people understand what a like-kind exchange is, we have found that it is in the best interest of our clients to work with an experienced advisory team. After executing hundreds of exchanges for our clients, we have developed the ability to foresee and correct potential problems before they exist. Our advisors are here to oversee your 1031/1033 exchange and ensure that it is successfully completed as smoothly as possible.
Section 1031 – 1031 Exchange of Real Estate
Section 1031 of the Internal Revenue Code provides that property held as rental or investment property or property used in your business (“relinquished property”) can be exchanged for “like-kind” property also held as rental or investment property or property used in your business (“replacement property”) allowing you to defer your Federal, state capital gain and depreciation recapture income tax liabilities.
With careful tax planning, your tax advisors and Avison Young can assist you in not only deferring these three taxes but also:
- accelerating depreciation deductions on the replacement property via cost segregation
- selecting replacement property in a low or no-state tax jurisdiction
- illustrate tax-advantaged cash flow projections maximizing “fresh basis” acquired in replacement property selection above your net sales price in a like-kind exchange
- further engage in “basis-mapping” to allow for estate planning and tax minimization
Section 1033 – Involuntary Conversions
Q&A with SmolenPlevy’s Dan Ruttenberg & Matt J. Campione
Avison Young asked Dan Ruttenberg and Matt Campione from SmolenPlevy in Vienna, VA to explain §1033 Involuntary Conversions as it applies to real estate. Founded in 1977, SmolenPlevy (smolenplevy.com) provides high quality legal representation to individuals, families and businesses. Mr. Campione served for many years as a Senior Tax Law Specialist in the National Office of the Internal Revenue Service and as a tax partner in Reznick, Fedder and Silverman (currently known as the Reznick Group) before joining SmolenPlevy in 2001. Mr. Ruttenberg joined SmolenPlevy in 1997. In addition to his law degree, Mr. Ruttenberg has a Master of Laws in Taxation and is licensed as a Certified Public Accountant.
Avison Young: What is a §1033 Involuntary Conversion Exchange with regard to real estate?
SmolenPlevy: Internal Revenue Code Section 1033 allows taxpayers to defer the capital gains associated with real property that has been involuntarily converted when they purchase similar replacement real property. If you are familiar with a §1031 Like-Kind Exchange, it works similarly.
Avison Young: What is considered an “involuntary conversion” for purposes of a §1033 Exchange?
SmolenPlevy: The most commonly thought of involuntary conversion is eminent domain. That is when the government takes your property for its own purposes such as building a new road. In exchange for your property, the government gives you the fair market value of your real estate and you would typically have to pay capital gains on the transaction as if you voluntarily sold it to any third party. However, an involuntary conversion also includes a sale of property under the threat of condemnation as well as the destruction of property from fire, flood, etc.
Avison Young: Are there any restrictions on the replacement property one can buy?
SmolenPlevy: Most of the time, we are dealing with property that is condemned or sold under threat of condemnation. Such involuntarily converted real property may be replaced by real property which is “like-kind” in nature. Like-kind property is a fairly broad standard. For example, an apartment is like-kind to a farm and improved property is like-kind to raw land. However, if other types of property are involuntarily converted, you are subject to a stricter standard. In such a case, the replacement property must be “similar or related in service or use”. For example, your house should be replaced by another house, although you could purchase raw land subject to a construction contract. This is generally not an issue as you would usually replace your house with another home.
Avison Young: Why wouldn’t I just do a §1031 Like-Kind Exchange if my real estate is involuntarily converted?
SmolenPlevy: First of all, a §1031 Like-Kind Exchange only applies to property used in a trade or business or held for investment purposes. Therefore, you cannot take advantage of §1031 if your home is involuntarily converted. Second, the rules under §1033 are much more flexible than the rules under §1031. For example, the sales proceeds in a §1031 Exchange must be held by a Qualified Intermediary such as the ES Group until they are used to purchase the replacement property. However, the property owner can hold their own funds in a §1033 Involuntary Conversion Exchange. Also, when dealing with property that is used in a trade or business, or held for investment purposes, the taxpayer has 3 years to purchase the replacement property instead of the 180 days one would have in a §1031 Like-Kind Exchange.
Avison Young: What are the common pitfalls in this area for taxpayers subject to this provision?
SmolenPlevy: You have to be careful to preserve the identity of the party eligible for the tax free roll over of proceeds. These rules are similar to rules regarding which party is eligible for §1031 Like-Kind Exchange treatment. For example, if real property held by a partnership is taken or sold under threat of condemnation, it is the partnership that must purchase the replacement property within the time period allowed. The partners cannot individually reinvest the proceeds. A recent private letter ruling, PLR 200921009, provides an interesting example of how the eligibility can be fractured through a creative use of partnership taxation rules. Similar to a §1031 Like-Kind Exchange, the taxpayer has to be careful to buy enough replacement property to avoid recognition of income. §1033 is fairly technical and has many rules. The bottom line is that this is not something someone should try without the guidance of qualified professionals.
Definition – noun: Money or property received in compensation for a damage or loss by casualty, condemnation, or theft. Profit realized on involuntary conversion is generally tax-free if it is invested in a property similar to the damaged or lost one within a certain period of time.
Along with handling §1033 Involuntary Conversion Exchanges and other real estate matters, SmolenPlevy is a respected leader in the areas of succession planning for businesses, general corporate law, estate planning, estate administration and family law.NNN 1031 Exchange