Posts

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.

What You Need To Know to Make Taxes Less Taxing

This guest post was originally posted on National Land Realty‘s blog.

Disclaimer: This article is not intended to be construed as professional tax advice, always consult with your tax or financial advisor for additional information on how this will impact your personal or business tax situation.

As Margaret Mitchell wrote in Gone With The Wind: “Death, taxes, and childbirth! There’s never any convenient time for any of them.” Land experts know how draining taxes can be.

The taxes associated with land sales are complex, and as soon as you feel like you’ve got a good grip on them, tax laws change! Even with the many changes that happen, there are some things that are set in stone. In this article, we take a look at the backbone of land taxes.

1031s Are Your Best Friend

Instead of paying taxes on the sale, 1031 exchanges let you invest the proceeds of your sale into a like-kind property. You can defer paying federal and state capital gains taxes.

If you’ve sold land before, you are probably familiar with using 1031s for land sales. But did you know that you can also sell conservation easements, water rights, development rights, and more while deferring taxes as well? This can save you hundreds or even thousands in tax dollars.

Although 1031s are an amazing resource for land buyers, there are strict rules about which properties do and do not qualify for this program. Be sure to check with a local land expert to see if your property qualifies before selling. You can also get started by reading through some official guidelines from the IRS.

Unique Tax Rules For Different Kinds of Land

Different land types come with different benefits and drawbacks.

  • Timberland: Each state taxes timber differently. For example, in Texas, timberland property is taxed by the appraised value multiplied by the tax rate. In Massachusetts, the tax is five percent of fair cash value, plus an enrollment fee and eight percent yield tax. To check your state’s unique rules, check out this handy website.
  • Vineyards: Small-time vineyard owners could be entitled to a sweet tax credit for making American wine. This Title 27 credit applies to producers who make under 250,000 gallons of wine a year in America. You can get up to a nine percent tax deduction. Bottoms up!
  • Agriculture: The most recent tax bill made many changes favorable for agriculture. Starting in the 2018 tax year, farmers can immediately write off up to one million dollars of capital purchases such as breeding livestock, farm equipment, and single-purpose structures.

Capital Gains Tax

A capital gain is defined as a profit from the sale of property or of an investment. This gain is taxable at the state level and the federal level.

This is where capital gains gets tricky. Each state has its own rules. In states like Texas or Nevada, you can expect to pay around twenty-five percent. In California or New York, you can expect to pay upwards of 30 percent! Here’s a tool from SmartAsset that can help you get a rough estimate of what you can expect to pay.

How High Are Capital Gains Taxes in Your State?

https://taxfoundation.org/how-high-are-capital-gains-taxes-your-state/

No one enjoys paying taxes. But having a solid sense of the fundamentals of land taxes can help you save your hard-earned money and make you (and your clients!) the most profitable deal possible. 1031 Exchanges are such a dense topic that we can’t possibly cover all there is to know in this article. If you’re a land pro and you’d like to learn more about helping your clients take advantage of 1031s, check out RLI’s November VILT-online course: Tax Deferred 1031 Exchanges. If you’re a landowner looking to learn more about how your property can benefit from these, make sure to contact a land expert near you to learn more.

About the Author: Laura Barker is the Membership and Communications Specialist for the REALTORS® Land Institute. She graduated from Clark University in May 2017 and has been with RLI since October 2017.