Post Hurricane Updates – Investment Cleanup Part 3- §1033 Exchanges

Inter­nal Rev­enue Code Sec­tion 1033 gov­erns the tax con­se­quences when a prop­er­ty is com­pul­so­ri­ly or invol­un­tar­i­ly con­vert­ed in whole or in part into cash or oth­er prop­er­ty.  This is com­mon­ly referred to as an “invol­un­tary con­ver­sion” since the loss of prop­er­ty is beyond the con­trol of the tax­pay­er and real­ize gain because the insur­ance or con­dem­na­tion pro­ceeds exceed the own­er’s tax basis in the prop­er­ty.

Octo­ber 25, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

What is a Sec­tion §1033 Exchange?

In the after­math of the hur­ri­canes investors may face a deci­sion on what to do with their prop­er­ty. In some loca­tions investors who will col­lect insur­ance pro­ceeds may not be able to rebuild their prop­er­ty. This may be caused by local build­ing codes being changed from when the investor pur­chased the prop­er­ty and cur­rent build­ing codes.  This can be seen in coastal areas where small cot­tages built in the 1950’s and 1960‘s now need to be built up rather than on grade.  This adds to the over­all cost of replace­ment.

Sec­tion 1033 does not require a Qual­i­fied Inter­me­di­ary (QI). In a Sec­tion 1033 Exchange, the tax­pay­er can receive the sales pro­ceeds (insur­ance pro­ceeds) and hold them until the replace­ment prop­er­ty is pur­chased.  If not all the pro­ceeds are used towards acquir­ing the replace­ment prop­er­ty, the tax­pay­er is taxed on the dif­fer­ence. In addi­tion, replace­ment prop­er­ty can­not be acquired from a relat­ed par­ty. Sec­tion 1033 is a tax defer­ral strat­e­gy and does not elim­i­nate tax­es if there is cap­i­tal gain.

Events that may qual­i­fy for a §1033 include:

Case study 1: Investor owns an indus­tri­al build­ing that is an oper­at­ing busi­ness. The state wants to expand the road in front of the prop­er­ty and seeks to take the prop­er­ty by emi­nent domain. While the investor objects there is an award for the val­ue of the prop­er­ty. The award is for an amount greater than what the investor has paid for the prop­er­ty and there is a cap­i­tal gain sub­ject to cap­i­tal gains tax­es.

The pro­ceeds from the award are $750,000 with a loan of $100,000 that needs to be paid off. Investor plans to uti­lize a Delaware Statu­to­ry Trust (DST) with non-recourse loan in place. Investor secures a prop­er­ty with a 48% LTV ($360,000). The investor uses $390,000 in cash pro­ceeds (from the award) to bal­ance the exchange for a total replace­ment val­ue of $750,000. This result­ed in the abil­i­ty to pay off the exist­ing loan on the prop­er­ty of $100,000 extract a total of $260,000 in tax free pro­ceeds.  Investors who are open to uti­liz­ing a DST to com­plete the §1033 exchange may have access to addi­tion­al invest­ment cap­i­tal.

Case Study 2: Investor owns a res­i­den­tial invest­ment prop­er­ty in Flori­da that was near­ly destroyed by a recent hur­ri­cane. The prop­er­ty was acquired many years ago and has increased in val­ue due to the under­ly­ing land val­ue. The prop­er­ty is owned with a small mort­gage. The investor decides not to rebuild, file and insur­ance claim, and sell the prop­er­ty. If there is an increase in the val­ue of the prop­er­ty, the investor would be sub­ject­ed to cap­i­tal gains. Uti­liz­ing the §1033 the investor can replace the prop­er­ty with anoth­er prop­er­ty (with sim­i­lar use) and defer the cap­i­tal gains. The same sit­u­a­tion, as described above, exists if the investor increas­es the debt and can retain cash tax free. Enter a mul­ti­fam­i­ly DST sat­is­fy­ing the sim­i­lar use with non-recourse debt enabling cash to be accessed with no tax impli­ca­tion.

Com­par­ing §1033 vs. §1031

We pro­vid­ed a brief overview of the 1033 tax deferred exchange in a pre­vi­ous sec­tion. There are a few oth­er con­sid­er­a­tions uti­liz­ing a §1033 deferred exchange with regards to the replace­ment prop­er­ty. The §1031 has a “like-kind” ref­er­ence regard­ing prop­er­ty to be acquired. “Like-kind” would enable the exchang­er to relin­quish a vacant land par­cel and replace it with an apart­ment build­ing or oth­er com­mer­cial prop­er­ty as long as it is real prop­er­ty. In Part 2 of this short series, we cov­ered §1031. Post Hur­ri­cane Updates – Invest­ment Cleanup Part 2- §1031 Exchanges — DST Edu­ca­tion and Mar­ket News

 §1033 has a more spe­cif­ic require­ment of “sim­i­lar use”. For exam­ple, if your prop­er­ty tak­en by emi­nent domain was an indus­tri­al prop­er­ty then your replace­ment prop­er­ty needs to be an indus­tri­al prop­er­ty (sim­i­lar use). If you lost an office build­ing to a dis­as­ter, then you need to replace it with anoth­er office build­ing (sim­i­lar use).

As not­ed above, addi­tion­al debt can replace equi­ty in a §1033 exchange as com­pared to a §1031 exchange where you may not use debt to replace equi­ty. In a §1031 exchange sell­ing a $500,000 prop­er­ty with a $100,000 loan being paid off, requires you to replace the $100,000 debt with anoth­er loan (or addi­tion­al cash) and then uti­lize the bal­ance of the pro­ceeds ($400,000) to com­plete the exchange. Con­trasts that with a $500,000 award (using same dol­lar amount as pre­cious exam­ple) for your prop­er­ty tak­en in an emi­nent domain event or hur­ri­cane you may exchange using a §1033 exchange. If you as an investor take on addi­tion­al debt of $100,000 more than the $100,000 debt being paid off for a total of $200,000, the investor would only need to use $300,000 of pro­ceeds to com­plete the exchange.  The $100,000 pro­ceeds not uti­lized may be retained by the exchang­ors as tax free pro­ceeds.

If the investor increased the debt amount (ref­er­enced above) then the investor would need to take on addi­tion­al respon­si­bil­i­ty and lia­bil­i­ty for the debt. DSTs may pro­vide sig­nif­i­cant ben­e­fits to investors who uti­lize a DST in a §1033 exchange, espe­cial­ly if there is debt that needs to be replaced. DST uti­lizes non-recourse loans.

Investor Restric­tion:

DST’s (Delaware Statu­to­ry Trusts) are for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and com­pli­ment your finan­cial objec­tives. 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, in any form, 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. 

SOCIAL MEDIA

Social Media plat­forms are sole­ly for infor­ma­tion­al pur­pos­es. Advi­so­ry ser­vices are only offered to clients or prospec­tive clients where the advi­so­ry firm and its rep­re­sen­ta­tives are prop­er­ly licensed or exempt from licen­sure. Past per­for­mance is no guar­an­tee of future returns. Invest­ing involves risk and pos­si­ble loss of prin­ci­pal cap­i­tal. No advice may be ren­dered by NAMCOA unless a client ser­vice agree­ment is in place.