1033 Tax Deferred Exchange — A rescue vehicle?

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 ™
adinicola@namcoa.com
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

IRC §1031

• 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). 

IRC §1033

• 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.      

Final Thoughts

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 adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC