Know More About… 1033 Exchanges

Part of the Internal Revenue Code since 1921, Section 1033 provides guidance for the deferral of all tax liability incurred when, as the result of an involuntary conversion, compensation received produces a capital gain.  Known as a “1033 Exchange,”  property owners can avoid current taxation by reinvesting their conversion proceeds into qualified replacement property within specified time periods.

The team of professionals at Fortitude Investment Group offer exceptional knowledge and years of experience in resolving even the most complex of exchange scenarios.  Skilled at utilizing this powerful tax code (as well as 1031), Fortitude can structure exchange solutions that will defer, possibly eliminate, the significant tax burden levied upon conversion proceeds, allowing property owners to keep more of their settlement dollars, tax-free.

1031 vs 1033: The Basics of Tax Deferred Exchanges

Both Section 1031 and Section 1033 of the Internal Revenue Code provide for the nonrecognition of gain when property is exchanged for qualifying replacement property. While similar in purpose, there are distinct rules separating the two which must be followed closely in order to complete a valid, fully tax-deferred exchange.

1033 Replacement Periods

Section 1033 of the Internal Revenue Code of 1954 provides for the nonrecognition of gain when property is compulsorily or involuntarily converted. Section 1033(a) requires that such conversions occur "as a result of destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." If an involuntary conversion results in a gain, the gain need not be recognized if the proceeds are invested in similar property of equal or greater value within a specified period.

Important in determining a property owner’s replacement period are several criteria, including the type of property and its use at the time of conversion, as well as the kind of property to be acquired. In addition, the manner of conversion (e.g., eminent domain vs. destruction) will dictate the time allowed for replacement.

Regarding involuntary conversions by eminent domain, the start of the replacement period is triggered by the earlier of three dates:

1. Date the property was condemned or seized
2. Date the property was first subjected to threat or imminence of condemnation or seizure
3. Date the property was sold or exchanged under threat or imminence of condemnation or seizure

The replacement period for conversions arising from theft or destruction (usually compensable through insurance payouts) begins on the date the incident occurred. Destruction of property, for purposes of §1033, is analogous to casualty under §165 as an involuntary conversion of property arising from fire, storm, shipwreck, or other casualty.

Pursuant to 1033(a)(2)(B), the replacement period ends two years after the close of the first taxable year in which any part of the gain upon the conversion is realized. For example, compensation received any time in 2017 must be invested into similar property by December 31 of 2019 to qualify for tax deferral. Although difficult to obtain, the replacement period may be extended with permission from the IRS.

Special rules apply to investment real estate converted by seizure, requisition or condemnation (or threat or imminence), but not by theft or destruction. 1033(g)(4) expands to three years the replacement period for property held for productive use in trade or business, or for investment.

The replacement period for personal residences destroyed by a Federally declared disaster is extended to 4 years.

Qualified Replacement Property: Similar or Like-kind?

Section 1033 of the Internal Revenue Code of 1954 provides for the nonrecognition of gain when the property is compulsorily or involuntarily converted. Section 1033(a) requires that such conversions occur "as a result of destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." If an involuntary conversion results in a gain, the gain need not be recognized if the proceeds are invested in similar property within a specified period.

Replacement property qualifies under this section if it is "similar or related in service or use to the property so converted." The IRS is quite restrictive in its interpretation of the similar use standard:

• Reinvestment must be made in "substantially similar" property;
• Reinvestment must be a substantial continuation of the prior commitment of capital and not a departure from it;
• Character of the investment should not be changed (although replacement property need not duplicate the converted property);
• Transaction should allow a taxpayer to return as closely as possible to his original position 1033(g)(1) provides a more lenient test for condemned real property “held for productive use in trade or business or for investment,” considering property of a like-kind to be similar or related in service or use. Like-kind property has a broader definition than does similar property. §1031(a)-1(b) provides that properties are of like-kind or like class if they are of the same nature or character, even if they differ in grade or quality. The most common example is rental income real estate replaced with other rental income real estate. Use by the tenants is not required to be similar, and can differ. 

Property that does not qualify as like-kind may still be eligible under the service or use test, which the IRS has divided into two tests. Revenue Ruling 64-237 presents the distinction between two classes of owners: the owner-user and the owner-investor.

A functional test applies to owner-users. Property is not considered similar or related in service or use unless the physical characteristics and end uses of the converted and replacement properties are closely similar. For example, owner-users of a manufacturing plant must reinvest in replacement property having the same end use - another manufacturing plant. A warehouse would not qualify.

Determination of similar service to the owner-investor is focused on the similarity in the relationship that both properties have to the owner. In applying this test, the nature of business risks associated with the property, the management and service demands of the owner, and relationship to the tenants must be considered. Owner-investors can benefit from eased replacement standards, as the replacement of investment property with property of like-kind is treated as similar.

Examples of Similar in Use Property

• Improved rental property replacing unimproved land subject to construction contract
• One building replacing two buildings used for the same purposes
• Replacement of destroyed facilities on leased land in one location by construction of similar facilities on leased land in another location
• Stock in public utility corporations replacing stock in condemned private utility

Examples of Property Not Similar in Use

• Improved real estate replacing unimproved real estate
• Reduction in leasehold or mortgage indebtedness replacing real property
• Interest in real estate investment trust replacing leased commercial building
• Shopping center replacing underdeveloped land
• Partnership interests replacing partnership assets

Examples of Like-Kind Replacement Property

Most real estate is considered like-kind to other real estate. Improved real estate is like-kind to unimproved real estate as both are the same kind of property (real property).

• Investment realty replacing condemned business realty, or vice-versa
• Duplex for a retail property
• Single family rental for a multi-family apartment
• Commercial property replacing condemned agricultural land
• Conservation easement replacing timberland, farm land or ranch land, provided easement qualifies as an interest in real property under law

Examples of Property That is Not Like-Kind

• Constructed motel on land previously owned replacing condemned mobile home park
• Personally-used residence replacing leased residential property
• Interest-bearing bonds and a savings account replacing income producing real estate
• Fee simple interest replacing 15-year leasehold
• Partnership interests in oil and gas properties replacing condemned oil and gas wells

What Are Delaware Statutory Trusts?

A Delaware Statutory Trust (DST) is a legally recognized trust, used in a variety of transactions and structures. Its flexibility of operation and management, plus the limited liability granted to beneficial owners, have made the DST a popular vehicle for a wide array of business purposes.

In accordance with I.R.S. Revenue Ruling 2004-86, beneficial interests in a Delaware Statutory Trust may be considered “like-kind” replacement property in a Section 1031 or Section 1033 exchange. Title to property is held by the trust as a separate legal entity for the benefit of a beneficial owner, rather than directly, affording liability protection to the owners. Interests in the DST are considered securities under federal securities law, however, they retain treatment as ownership in real estate.

For exchange purposes, DSTs are 100% passive, turn-key investments offered by nationally reputed real estate management companies, referred to as “sponsors.” Sponsors perform the initial due diligence, structure the property acquisition, maintain and lease the property, collect rent, service the mortgage and eventually sell the property. A DST may own one or more properties across diverse asset classes: multifamily residential real estate; net leased retail; medical office portfolios; industrial property, among others.

If leverage is used to purchase the property, the trust serves as the borrower under a non-recourse loan, yet the owners enjoy the benefits of this debt with no effect on credit ratings. Net cash flow from operations, if any, is distributed on a pro-rata basis to the owners, as are depreciation pass-through and interest deductions.

Delaware Statutory Trusts:

• Can be purchased in any dollar amount (within limits), facilitating the “equal and up” replacement requirements for full tax deferral under 1031 and 1033;
• Allow the investor to own a fractional interest in large, institutional quality and professionally managed commercial property;
• Act as single borrower of any debt, eliminating the need to underwrite individual investors;
• Produce tax-favored, passive income potential, which becomes tax-free when offset by unused passive losses
• Provide asset and liability protection;
• Allow for low minimum investment amounts, providing the opportunity for diversification into several DSTs.

What Are Delaware Statutory Trusts?

In order for a DST to be treated as a grantor trust and qualify as direct interest in real estate for exchange purposes, the IRS has set forth parameters that must be met, pursuant to Rev. Proc. 2004-86, known as the “7 Deadly Sins”:

• Once the offering is closed, there can be no future capital contributions to the DST by either current or new beneficiaries.
• The trustee cannot renegotiate the terms of the existing mortgage loans nor can it obtain any new mortgage financing from any party except where a property tenant is bankrupt or insolvent.
• The trustee cannot enter into new leases or renegotiate existing leases except where a property tenant is bankrupt or insolvent.
• The trustee cannot reinvest the proceeds from the sale of its real estate.
• The trustee is limited to making the following types of capital expenditures with respect to the property:
  (a) expenditures for normal repair and maintenance of the property,
  (b) expenditures for minor non-structural capital improvements of the property, and
  (c) expenditures for repairs or improvements required by law.
• Any cash held between distribution dates can only be invested in short-term debt obligations.
• All cash, other than necessary reserves, must be distributed on a current basis.

The typical trust agreement provides that if the Trustee determines that the DST is in danger of losing the property due to its inability to act because of these parameters, it can convert the DST into a limited liability company (referred to as the Springing LLC) with pre-existing agreed-upon terms.

The laws of the state of Delaware permit the conversion to a limited liability company through a simple filing with the office of the Secretary of State. In a conversion, the Springing LLC is treated as the same entity as the DST. This means that, for purposes of Delaware state law, there is no real estate transfer or change in the borrower. The operating agreement for the Springing LLC will contain the same Special Purpose Entity (SPE) and bankruptcy remoteness provisions that are contained in the DST’s trust agreement. However, it will not contain the prohibitions against the “seven deadly sins” and thus will permit the raising of additional capital contributions, the raising of new financing, the renegotiation of the terms of the existing financing, or entering into new or modified leases. In addition, it will provide that the trustee (or sponsor) will become the manager of the Springing LLC.

1033 and Tax-Free Conversion Proceeds

One of the most powerful provisions of 1033 is the ability to replace equity in the converted property with new debt on the replacement property, a transaction strictly prohibited by §1031. By increasing the debt, the “equal and up” replacement requirement can be accomplished with less reinvestment of the conversion proceeds. This process also creates an opportunity for a refund if the tax has already been paid.

Example 1: Gain not reported

In May of 2019, an investor had rental property taken through the process of eminent domain, receiving compensation of $1,000,000 in October 2019. An election for nonrecognition under Section 1033 is made on the 2019 tax return. 1033(a)-2(A) requires the property owner, by December 31, 2022, to purchase qualifying replacement property valued at $1,000,000 or more for full tax deferral.

In February of 2020, the investor purchased beneficial interests in a Delaware Statutory Trust. The trust acquired a 300 unit luxury apartment complex with 47% cash and a mortgage of 53%, a loan-to-value (LTV) of 53%. By investing $470,000 of equity and adding $530,000 of new, non-recourse financing, the property owner has purchased replacement real estate valued at $1,000,000, fulfilling the requirement of §1033(a)-2(A), resulting in full deferral of the gain. The remaining proceeds of $530,000 need not be reinvested in replacement property and is completely tax free to the owner.

Highly leveraged DSTs (75%-80% LTV) have been structured for this purpose, as well as other advanced exchange techniques. In the scenario above, $750,000 to $800,000 would be retained in cash, free of tax by investing $200,000 to $250,000 of the $1,000,000 award.

Example 2: Gain reported

In May of 2019, an investor had rental property taken through the process of eminent domain, receiving compensation of $1,000,000 in October 2019. Gain was reported and paid in April of 2020.

In 2021 (still within the replacement period), a DST holding title to 16 brand-name stores with a loan-to-value of 78% is purchased as qualified replacement property and designated as such on the 2019 return. By investing $220,000 of equity and adding $780,000 of new, non-recourse financing, the property owner has purchased replacement real estate valued at $1,000,000, fulfilling the requirement of 1033(a)-2(A).

Pursuant to IRC §6511, the property owner can, until April of 2023, file a claim for refund of 2019 taxes paid (three years from the due date of the 2019 return). In the scenario above, the property owner can receive a refund of the tax paid in 2020, and retain the remainder of the proceeds not invested in the replacement property - tax free. 

While replacement property and financing can be secured personally by the owner, DSTs facilitate the process as the debt is already in place without the need for lender approval. Due diligence has already been completed, and closings can take place in a matter of days. In addition, DSTs historically have benefitted from lower, institutional interest rates that may be unavailable to the public markets.

Examples are for hypothetical purposes only and actual properties and results will vary. DST properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last two years, and reasonably expects the same for the current year) and accredited entities only. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation.