It is spring. Flowers are blooming; the rivers swell with snowmelt from the mountains; newly thawed Northern ponds welcome the return of their ducks and geese; Florida convulses with an annual migration of revelers. It is only natural for the mind to turn to one of the two inevitabilities: Taxes.
Tax time
As the Ides of April approach for individual tax filers, a mad dash to find tax savings is underway. Many real estate investors and professionals are quite familiar with the tax saving potential of a 1031 Exchange. Named after a section number of the tax code at 26 U.S.C. § 1031—which governs certain exchanges of one piece of property for another piece of property—a 1031 Exchange allows a property owner to defer capital gains by acquiring a like-kind replacement property and essentially rolling in the proceeds of the sale of the first property into the purchase of the second. To qualify, a potential replacement property must be identified within 45 days of the sale of the original property. And, once identified, the owner has 180 days to acquire title to the replacement property. Additionally, during the replacement purchasing phase, the funds from the original property’s sale must be handled by a qualified intermediary. The use of such an exchange can present significant tax efficiencies, if the tax payer can meet the stringent deadlines.
In the world of eminent domain, a similar concept exists. Under 26 U.S.C. § 1033, the aptly named 1033 Exchange is similar to its 1031 sibling. Both allow a property owner to defer capital gains from the sale of real property by acquiring a replacement “like-kind” property. (For those of you wondering about the nonsequential numbering of 1031/1033 Exchanges—a 1032 Exchange is the exchange of stock for property.)
However, the 1033 has some significant differences that are worth exploring. First and foremost, a 1033 Exchange is only available when property is “compulsorily or involuntarily converted.” 26 U.S.C. § 1033(a). Such a compulsory or involuntary conversion may be established when the property is acquired through the exercise of eminent domain through condemnation, or when there is the threat of condemnation or the imminence thereof. Thus, when the government files a suit in condemnation to acquire property, the just compensation award will certainly qualify for use in a 1033 Exchange. But, the filing of a suit is not required. Once the government has determined to take a particular piece of property, that acquisition will generally be treated as an involuntary conversion because of the threat of condemnation. Not all government acquisitions of property are done under threat of condemnation. The government can and does buy real property from time to time on the open market on a purely voluntary basis. As such, when a government approaches a property owner about the potential purchase of property, it may be prudent for the property owner to seek guidance from counsel and tax professionals to determine whether the acquisition does or could qualify for treatment as a 1033 involuntary conversion.
Time, time, time
Perhaps in recognition of the practical difficulty a landowner can face when their property is either taken or acquired under threat of condemnation, the provisions of 1033 are generally more generous and flexible than a 1031 Exchange. First, there is no requirement to identify or declare a replacement property. This seems a wise policy choice. A 1031 Exchange based on a voluntary sale will generally be made by a person who has decided to enter the market at a given time. A 1033 Exchange, based on an involuntary acquisition, may happen to an individual who has not studied the market or identified a potential property for replacement. Relatedly, instead of a 180-day window to close on the replacement property, a 1033 Exchange provides a window of around two years. The base limit under 26 U.S.C. § 1033(a)(2)(B)(i) is two years after the close of the first taxable year in which any part of the gain upon the conversion is realized. There are special rules of time for certain types of productive properties and for properties damaged by federally declared disasters. The window of time generally runs from the receipt of funds. In a condemnation law suit, at least a potion of those funds are ordinarily provided to the landowner when the condemning agency makes its initial deposit. The landowner must elect to treat any gains as part of a 1033 Exchange. When an acquisition is made under threat of condemnation, the period runs from the close of the acquisition.
In the meantime
Another significant difference is the treatment of the proceeds of the liquidation of the original property. Under a 1033 Exchange, there is no requirement for a qualified intermediary. Instead, the funds may be invested in the short term. A low-risk investment is a prudent choice, because a 1033 Exchange must utilize the total value of the liquidated property. So, losses to an interim investment that take the property owner below that value can pose a difficulty. But, the flexibility in using the funds is a significant benefit. This may provide a tactical benefit for cases where the parties may need a year or more to resolve the ultimate measure of compensation. In the meantime, the landowner winds up being able to put the funds received in deposit to productive use as the case unwinds.
Sometimes it gets complicated
Condemnation actions can have certain unique aspects. For example, sometimes—quite often, actually— only a portion of property is acquired through condemnation in a partial taking. A landowner should consult with professionals to determine to what extent the compensation can be used for a 1033 Exchange. Or, sometimes—though much less common—an eminent domain proceeding can be abandoned by the condemning agency. Such a situation certainly calls for the guidance of counsel.
