Put aside the known risks of real estate, with its value fluctuations and interest rate dynamics. Let's talk about a financial hardship that nobody is discussing but is growing on pace with global warming: Property owners who face "involuntary conversions" that lead to significant financial and tax implications, whether a natural disaster, theft, or eminent domain. Fortunately, Section 1033 of the Internal Revenue Code could offer a valuable solution for mitigating this risk by allowing tax deferral on gains resulting from involuntary conversions. This article reviews Section 1033 and how it can be a lifeline for property owners and their professional advisors.
What is an involuntary conversion?
Imagine a wildfire sweeping through your community and destroying your home. Luckily, your homeowners’ insurance covers the total market value, but here’s the catch: you bought the property 20 years ago for much less. This insurance settlement triggers a taxable gain—the difference between the settlement and your adjusted cost basis—despite your lack of intention to sell. This is an example of an involuntary conversion.
Who are the candidates for IRC Section 1033?
Involuntary conversions, though not daily events, are not uncommon. Natural disasters, eminent domain, and theft or vandalism are frequent triggers. Climate change, urban expansion (leading to more eminent domain), and rising crime rates increase these risks, making property owners in affected areas prime candidates for utilizing IRC Section 1033.
Understanding Section 1033: The Basics
Involuntary conversions often result in compensation that exceeds the property's original purchase price or adjusted basis, leading to a realized gain. This gain is usually taxable, adding financial sting to a stressful situation.
However, Section 1033 allows taxpayers to defer the recognition of this gain if they reinvest the proceeds or compensation into similar or related property within a specified period. This deferral can provide flexibility and financial relief, including time to reinvest without the immediate requirement of paying capital gains.
Key Features of Section 1033
Tax Deferral: To qualify, the replacement property must be similar or related in service or use, and the reinvestment must occur within two years (or three years for condemned properties) from the end of the tax year in which the taxpayer realized the gain.
Primary Residence, Vacation, and Investment Properties are Eligible: Unlike Section 1031, where only real estate placed in service for business is eligible, all real estate for personal or income use is eligible under Section 1033.
Direct Access to Funds: Unlike Section 1031 exchanges, taxpayers can directly receive (take personal possession) and use the funds from insurance or government compensation, provided they adhere to the reinvestment requirements. By contrast, if an investor took possession of proceeds in a 1031 exchange, the tax-deferred exchange would be immediately disqualified.
No Qualified Intermediary Required: Unlike the requirements for Section 1031 exchanges, Section 1033 does not require a qualified intermediary to administer the transaction.
Example 1: Rebuilding After a Natural Disaster
Consider Steve, who owned a rental property in a Florida coastal area prone to hurricanes. After a devastating storm destroyed the property, Steve received an insurance payout of $1,000,000. His original basis in the property was $300,000, so the payout would result in a $700,000 realized gain.
Steve decides to use Section 1033 to defer the tax on this gain. Within two years of receiving the insurance proceeds, he purchased a new rental property in Austin, Texas, for $1,100,000. By doing so, Steve defers the $700,000 gain and avoids immediate tax liability. His latest property has a basis of $400,000 ($1.100,000 purchase price minus the deferred gain of $700,000).
This strategy allows Steve to rebuild his investment portfolio without the financial strain of a large tax bill and mitigates the interruption of building his real estate portfolio.
Example 2: Navigating Eminent Domain
Karen owned a small commercial property that the local government decided to acquire for public use. She received $800,000 in compensation. Her adjusted cost basis in the property was $500,000, resulting in a $300,000 gain.
To utilize Section 1033, Karen reinvests the compensation into a new commercial property in a different city for $900,000 within three years of the government's payment. By reinvesting in a similar business use property, she defers the $300,000 gain and secures a new asset for her business operations.
Karen's newest property has a basis of $600,000 (the $900,000 purchase price minus the $300,000 deferred gain). Exercising Section 1033 allows her to continue her business without the immediate tax impact, focusing on growth and adapting to the new location.
Conclusion
Section 1033 is a powerful tool for property owners to navigate the complexities of involuntary conversions. Deferring taxes on gains offers a pathway to financial recovery and reinvestment without the immediate burden of capital gains tax. For professional advisors, leveraging Section 1033 can be valuable in helping clients defer taxes and supporting them through personal and financial challenging times.
About the author/planner/teacher
As the Founder and CEO of The Real Estate Whisperer™ Financial Planning, Rich Arzaga, CFP®, CCIM is a flat-fee financial advisor who provides advice only. By focusing solely on providing client-centered financial advice rather than managing investments, he ensures his undivided attention to his clients' needs.
Drawing on his extensive expertise, Rich provides valuable advice on various real estate topics, including buy-sell-hold strategies, tax-deferred and highly appreciated tax reduction strategies, real estate succession planning, and rental property cash flow analysis.
His exceptional knowledge and real estate strategies have earned him recognition in business and finance publications such as the Wall Street Journal, The New York Times, Newsweek, Kiplinger, and The Journal of Financial Planning. As an esteemed adjunct professor at UC Berkeley and UC Santa Cruz Personal Financial Planning programs, Rich has been Honored for his excellence in teaching.
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