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Knowing The Difference Between 1031 Versus 1033s in Land Real Estate

As real estate professionals, we have a fiduciary responsibility to help our clients achieve their goals relating to real property. Often times, these goals revolve around maximizing the return the client will achieve either during the acquisition or disposition of their real estate assets. A valuable tool in this process is the like-kind exchange. This tool could permit non-recognition of a gain for tax purposes, allowing our clients to invest ALL of the proceeds from a sale into a new asset.

As land professionals, many of us encounter owners of raw land assets that generate very little cash flow, or worse, don’t have potential to generate income. The ability to sell this passive asset without any tax exposure and exchange into a cash flow asset such as an apartment building or net leased shopping center is a power motivator that can in many cases, substantially increase our client’s income and positively impact their lives.

As investors, it is imperative that you seek the guidance of your tax advisor, a Qualified Intermediary (QI), and a real estate professional well before considering a disposition or acquisition to ensure the transaction is structured appropriately to achieve your overall financial goals.

What is a 1031 Exchange?

Since 1921, Internal Revenue Code (IRC) Section 1031 provides for the opportunity to defer payment of capital gains tax liability by reinvesting the proceeds from the sale of a relinquished property into another similar asset. There are many nuances to the code but generally, to exchange from one asset to another, the proceeds of a sale must be reinvested into a “like-kind” property. “Like-kind” refers to the character of the asset, not the quality. For example, property purchased and held for investment purposes may be exchanged for another investment property. The properties can be land, apartments, or different so long as they are both held for investment. Conversely, a primary residence being sold and exchange into an investment asset would NOT qualify. So long as the process is followed, the taxes are not eliminated but payment of the taxes is delayed until such time as the gain is realized when the acquired asset is sold, without being exchanged further.

This does not require an investor to trade their real estate straight across or sell their relinquished property and acquire a replacement property at the same time.  By using a QI, investors are given a certain period of time to complete the acquisition of their replacement property.

What is a 1033 Exchange?

Similar to IRC Section 1031, Section 1033 provides for non-recognition of gains and deferral of the tax liability. The primary difference is that a 1033 exchange can be used only when the property is being relinquished through a “forced-conversion.” Examples of “forced-conversion” would be taking by eminent domain or loss from a natural disaster, even if insurance proceeds are received.

While similar, there are distinct differences between the two.  Below are highlights of some of the rules and how they differ between the 1031 and 1033 exchange.

 

  1031 1033
Use Exchange of real property held for productive use in a trade or business or for investment. Exchange of property compulsorily or involuntarily converted as a result of eminent domain, destruction, or theft.
“Even and Up Rule” – Equity Equity in the replacement property must be even to or greater than the net equity of the relinquished property.

 

Equity cannot be replaced with additional debt.

Cost of the replacement property must be even to or greater than the net proceeds received.

 

Equity can be replaced with additional debt.

“Even and Up Rule” – Debt The amount of debt on the replacement property must be even to or greater than the amount of debt relieved on the relinquished property.

 

Debt can be replaced with additional equity (i.e. cash).

The value of debt on the replacement property must be even to or greater than the value of debt relieved on the property converted.

 

Debt can be replaced with additional equity (i.e. cash).

Replacement Property Criteria Like-Kind Similar or related in service or use
Notification Period Within 45 days of the disposition, must notify the Qualified Intermediary of the potential replacement properties. Identification of potential replacement properties is not required.
Timing Within 180 days of disposition, escrow must close on all replacement property. Within 2 years from the end of the first tax year in which gain is realized, escrow must close on all replacement properties. Special rules extend this period to 3 or 4 years.
Vesting The same taxpayer that sold the relinquished property must purchase the replacement property. The same taxpayer that sold the relinquished property must purchase the replacement property.
Improvements Exchange funds cannot be used to improve land already owned. Conversion proceeds can be used to improve land already owned.
Related Parties In most cases, the replacement property cannot be acquired from a related entity. In most cases, the replacement property cannot be acquired from a related entity.


Reverse 1031 Exchange

On September 15, 2000, the Internal Revenue Service issued Revenue Procedure 2000-37. This explains how to complete a “Reverse 1031 Exchange,” a scenario where an investor acquires the replacement property prior to selling the relinquished property. In this scenario, a QI (through a special purpose entity) will act as the Exchange Accommodation Titleholder, acquire and hold or “park” legal title to either the relinquished property or the like-kind replacement property during the exchange.  This structure is more expensive and complex than a traditional exchange and should be reviewed with a tax advisor to ensure the investor’s specific situation warrants use of this structure.

Tax Cuts and Jobs Act

Signed into law on December 22, 2017 The Tax Cut and Jobs Act took effect on January 1, 2018 and substantially modified the IRC. Specific to Section 1031, the act eliminated personal property exchanges, limiting the ability to exchange assets to only real estate. It is now titled, “Exchange of real property held for productive use or investment.” However, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain as like-kind exchanges, if considered to be real property under applicable state law. 

State specifics and claw-back provisions

Particular care should be given to exchanges involving relinquished property and replacement property in different states. Many states have withholding requirements applicable to non-residents. Although most states allow investors to sell property in that state and exchange into property in another state and defer state taxes, some states have claw-back laws. Claw-back laws permit a state to recapture the state income tax when the out of state replacement property is sold.  To avoid potential double taxation, it is critical for an investor to research how the states they are dealing with treat these transactions.

This article is intended to be a primer on like-kind exchanges and highlight some of the nuances and considerations needed to successfully complete these transactions.  Nothing in this article should be considered tax or legal advice and any investor interested in learning more about exchanges should speak with their tax adviser and a Qualified Intermediary. 

About the Author: Matt Davis is a real estate broker with Cushman & Wakefield. He is based in San Diego, CA and assists clients with the disposition and acquisition of investment grade agricultural and transitional land assets. He is also founding member of the company’s Land Advisory Group and Agribusiness Solutions Team. Matt is a member of RLI and serves on their 2019 Future Leaders Committee.

The Next Generation of 1031 Exchanges

I am a big fan of old western movies. Regardless of the movie, either a cowboy or the 7th Cavalry always came to the rescue at the last moment to save the day. Predictably, one of my favorite actors is John Wayne. Whether he was chasing the bad guys in the old west, defending the Alamo, winning the Civil War, fighting the Japanese at the Battle of Midway or fighting our enemies at D Day, he always seemed to come to the rescue. That’s what I loved about him and I always wished that in some way, I could do the same.

As a tax expert, now I can. I may not be saving Shinbone from Liberty Valance or Europe during WW2 but I can come to the rescue when a property owner is going to sell a property that will create a large tax liability. That works for me. And for you.

When selling a great property, you can either pay taxes on the gains or transact a 1031 exchange to defer taxes. The first isn’t a good option and the second is not always appropriate or has limitations to be completed.

But here is where a tax expert can come to the rescue. There are numerous ways to defer taxes using the next generation of 1031s. Our Section 453 tax deferral strategies have a 20-year track record of successfully deferring taxes between 2000-2500 times with the largest transaction being $120 million with a tax deferral of $50 million.

If someone wants to transact a 1031 exchange and can complete it that’s great. To be on the safe side, we can guarantee that if a 1031 fails, the sales proceeds will NOT be sent to the seller which now creates a large tax liability but rather that taxes will be deferred, and the client now has unlimited time to find a replacement property.

Consider the following examples.

One of the main limitations in an exchange are the 45 and 180-day time periods. Supply of real estate properties can be elastic.   Sometimes there is a great supply of replacement properties and sometimes there isn’t. What if there were no time constraints to have to deal with.

What if you could sell a property today, defer taxes today and have unlimited time to find a great replacement property. Would that work? Absolutely.

But let’s take that thought to the next level. When transacting a 1031, you buy low and sell high but because of the 45-day period, you may have to buy high when market conditions may be less than favorable to your buyers. What if after you sold high, you had unlimited time to buy again so you could wait until market conditions became more favorable to buyers. Would that work?  Absolutely. And even better, while your buyer is waiting for market conditions to become more favorable, we will pay him a cash flow of 5-6% while he waits. So, using the next generation of 1031 s, you can buy low, sell high and buy better.

Say you have 4 owners of a property and all the owners want you to list their property BUT 2 of the owners want to take their proceeds and run to Vegas…not necessarily a bad strategy and the other 2 want to defer their taxes. Until you get everyone on the same page, you can’t list the property. Get your paperwork ready. The 2 that want to take the money and run can do so and the 2 that want to defer taxes can use our proprietary trust to do so. You get the listing and you owe me lunch. Preferably in Vegas.

Say that there is a property owner that has had a property in the family for 50, 60, 70 years or longer. He would like to sell but almost the entire sale will be capital gains and depending on where he is domiciled, taxes can range from roughly 25-40% so instead of selling, he decides to keep the property until he passes on and then his kids get the property with the stepped basis.

That’s not a bad strategy for everyone but you because you now can’t sell the property. Instead, what if you could explain to the prospect that you can sell today, defer taxes today, move closer to the grandkids today and receive a higher retirement income than if he sells and pays taxes first. And he can do all of this while alive.

You have a client that has transacted 1031 exchanges for decades and now that he has accumulated wealth, he would like to sell and retire. Unfortunately, he now has to sell and use the basis of the first property to determine taxes and the tax bill will be a whopper.

What if you have a 1031 Exit Strategy. That’s right. By using our trust, he can sell his property and defer taxes for the rest of his life and into the next generation if he chooses to do so.  By deferring taxes, he can enjoy the fruits of his labor by receiving a larger retirement income than if he would have sold and paid taxes first. You are his new best friend.

One last idea. Say that you come across someone that has a high end primary residential property and they want to sell. However, the sale will create a large tax liability to the sellers. You can sell their residence, defer taxes using our trust and help them buy another property any time in the future. That’s a great deal for them and you made a new friend.

These are just a few of our tax deferral strategies so make sure to call an expert in conducting 1031s to come to your rescue. John Wayne would be proud. It shows True Grit. I can’t believe that I typed that. Until the next time, Happy Selling.

David Fisher is the managing partner for Creative Real Estate Strategies, a national firm that can defer taxes on highly appreciated real estate when a 1031 isn’t appropriate or can’t be completed. He has been an RLI sponsor since 2006 and has sponsored over 40 RLI events nationwide. He can be reached at 713-702-6401 or david@cresknowsrealestate.com.