1033 Exchanges Offer More Flexibility for Owners

Hearing about owners that have lost all or part of a property due to condemnation often conjures up images of abandoned buildings or problem properties – not that Burger King or CVS sitting at a busy intersection. The reality is that cases of condemnation are more the norm for ordinary public infrastructure projects, and they could very well become more common after Congress approved the federal $1 trillion infrastructure spending plan. 

That CVS or Burger King sitting at a busy intersection may be subject to condemnation when a city needs to widen the roadway to accommodate a turn lane or bicycle lane. Such condemnations can trigger a capital gain event for the business or property owner – and an unwelcome tax bill. One way to defer that gain is to execute a Section 1033 exchange. 

And, no, that isn’t a typo. Many investors are familiar with a Section 1031 exchange that allows a property owner to defer capital gain on profits realized from the sale of one property when proceeds are reinvested in another “like kind” property. A 1031 exchange is commonly used in cases where a property owner wants to transition from a management-intensive property such as an apartment to a more passive investment such as a triple net lease restaurant. A 1033 offers much the same benefit along with a few key differences that give property owners greater flexibility to successfully complete their exchange. 

As always, you should consult your tax attorney before making any decisions regarding 1033 or 1031 exchanges. While we are experts in real estate sales, we are not tax or legal experts. Email us today if you’d like to chat with us about your 1031 or 1033 needs.

Involuntary capital gains events

A key point to start is that a 1033 applies specifically to cases of involuntary sales. Trigger events include property seizure, destruction, or theft. The most common is a condemnation or threat of condemnation from a government entity. A city or agency might use condemnation powers to pave the way for a variety of infrastructure projects, such as roads, bridges, or light rail transit, as well as the expansion of a hospital or university campus or the construction of affordable housing. 

Cities also can use condemnation to acquire blighted and abandoned property, or property that otherwise stands in the way of economic revitalization projects. Last year, for example, the city of Binghamton in New York announced that it planned to use its power of eminent domain to acquire Binghamton Plaza, a largely vacant retail center that it hopes to redevelop into a use that will benefit the community by creating more jobs and services, as well as raising the tax base.

“We see a lot of those partial property condemnations where a city might take a portion of a property running along a key roadway,” says Camille Renshaw, CEO and co-founder of B+E, a national real estate brokerage firm. “That condemnation might result in an owner that has $500,000 or $1 million – or more if it is an entire property – that they are trying to figure out how to place to avoid paying a capital gain,” she says.

Renshaw has first-hand experience with 1033s, both in helping B+E clients find replacement properties, as well as personally. Her family owns farmland in Tennessee. Several years ago, the Tennessee Valley Authority acquired a portion of their land for use in a flood control project. The family was able to successfully execute a 1033 exchange to offset their capital gain. 

Key differences in 1033s vs. 1031s

Although the tax strategy and the end goal are the same – deferring tax on a capital gain from a relinquished property by rolling proceeds into a replacement property – there are some key differences in a 1033 exchange that are advantageous for a property owner. 

Longer runway: 

• A 1031 exchange has a very tight timeline that includes a 45-day period to identify potential replacement properties and a 180-day window to close on the replacement property or properties. 
• A 1033 exchange allows for significantly more time, with a transaction that needs to close within two years of the end of the taxable year in which the gain will be recognized. If a property is relinquished in early 2023, a property owner would have all of 2024 and 2025 to complete the acquisition of replacement property and defer recognizing the gain.

Treatment of proceeds: 

• A 1031 exchange has strict rules related to how proceeds from a sale are handled. A property owner is required to work with a Qualified Intermediary who holds funds from the sale of a property in escrow and coordinates the transfer of funds at closing for the purchase of a replacement property. Essentially, the property owner never “touches” or takes control of proceeds during a 1031 exchange transaction. 
• In a 1033 exchange, a property owner can access and use proceeds from a sale however they choose as long as they reinvest in a property of equal value within the 2-year period.

Identifying replacement property

A 1033 also has some additional nuances. For example, whereas a 1031 exchange only applies to real property, the 1033 definition is somewhat broader as it applies to real property and also can include the value from the business use, such as equipment. It is always advisable to work with an accountant or tax professional to navigate a 1031 or a 1033 exchange to make sure you qualify and adhere to the rules, allowing for a successful exchange. It also is important to have an experienced broker at the table to assist in identifying a replacement property or properties, advises Renshaw.

“What we typically see is that people are very fatigued when they get through this condemnation process. In some cases, there are multiple family members or business owners involved, and negotiating fair value with the city or government entity along with all of the stakeholders can be a challenging process,” says Renshaw. People often come out of that process and want a much simpler investment. “The base case that we see is that it was a more hands-on multi-tenant asset, and they want a less cumbersome investment, such as a net lease QSR or gas station,” she adds.