This blog post was co-authored by Dan Raupp and Alan Lichtenstein.
For many investment property owners, the last several years may long be remembered for what was lost. From record-setting wildfires in the western U.S., to the high number of hurricanes that have battered the gulf coast and eastern seaboard, owners who lost investment property to natural disasters (or to eminent domain condemnations) have not only had to grapple with decisions about what to do next, but also have been confronted with hefty capital gains taxes.If you are one of the unfortunate owners, there are several important considerations you should be aware of. And tax relief may be at hand.
When a taxable gain is created by funds received from a casualty loss (fire, flood, earthquake, etc.) or the condemnation of property (eminent domain), property owners can find tax relief in the U.S. Tax Code. Section 1033 of the Internal Revenue Code allows for the deferral of taxes due, provided several specific guidelines are met. Known as a “1033 Exchange”, all taxes realized can be avoided or, potentially, eliminated by following the steps put forth by the I.R.S.
Section 1033 (a) (1) states that if all of the compensation received is used to purchase property “similar or related in service or use”, all taxes can be deferred. What constitutes “similar” depends on several factors: eminent domain vs casualty loss, personal vs business use/investment property, etc. The similar use standard tends to be more restrictive for personal use property, while investors subjected to condemnation can enjoy more lenient replacement rules. Additionally, some requirements are relaxed for investment property lost in Federally declared disaster areas.
1033 (g) allows for investment property taken by eminent domain (and certain casualty losses) to be replaced using “like-kind” rules. Under this standard, most real property is considered “similar” to other real property, allowing almost unlimited replacement options.
For example:
- Raw land could be exchanged for improved land
- Residential rental property could be exchanged for a medical building
- A strip mall could be exchanged for investment into two or more Delaware Statutory Trusts
Property Held for Business Use
To help illustrate which type of properties and scenarios qualify for tax deferral benefits under 1033 exchange rules, these examples may prove helpful.
- The Dept of Transportation condemns a two-family residence that you rent to others. You use all proceeds to purchase a small strip mall which qualifies as like-kind under 1033 (g)(1). All taxes are deferred.
- The Dept of Transportation condemns a 2-family residence that you rent to others. You use all proceeds to purchase an oceanfront vacation home which, as personal property, does not qualify as like-kind. Taxes are not deferred.
- Farmland was taken to build a school. You invested the proceeds into a DST that owns a Walmart distribution center. This qualifies as like-kind, and all taxes are deferred.
What About Property for Personal Use?
Whether lost to a natural disaster or by eminent domain, real property held for personal use, such as your primary residence or a vacation home, must be replaced with other personal use property: another home. Residential rental property is not considered similar in use and does not qualify as replacement property for your home. Here are a few examples:
- Your main home was destroyed by fire. You purchased a new home with all of the insurance proceeds. All taxes will be deferred.
- Your vacation home was destroyed by a hurricane. You purchased a 2-family home to rent to others with all of the insurance proceeds. Since investment/business property is not similar in use to a vacation home, no tax deferral has been created and a capital gain must be reported.
- Your home was taken by eminent domain to build a highway. You used all of the proceeds to buy a flower shop, which does not qualify as replacement property. 1033(g) does not apply to personal use property. A capital gain must be reported.
Do not Ignore Deadlines!
Many owners are familiar with the 1031 exchange as a strategy for selling investment property and purchasing replacement property while deferring taxes. The 1033 exchange provides similar tax deferral benefits but also has the unique advantage of allowing more time to reinvest.
For example, 1031 exchange rules require that a replacement property must be identified with 45 days of the closing on the relinquished property and closed on within 180 days. The 1033 exchange, in many cases, allows as much as two to three years for the proceeds to be reinvested. Also, if a property owner has already paid the tax and they are still within their replacement period, it is possible to purchase property, including DSTs, and claim a tax-free refund of their money.
If you have lost investment property due to natural disaster or condemnation and intend to reinvest in like-kind investment property using a 1033 exchanges, please contact us today. We can discuss DST options that can help you close on time and keep your tax deferral benefits intact!
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