When Property Goes Kicking and Screaming: the 1033 Involuntary Conversion Tax Election
The roof is leaking, the sill is rotting, the plumbing makes an outhouse smell good, the town has just stated that they’re going to build a bridge through the property, yet your little sister is interested in buying the place. If she’s a real estate investor, buying a property like this may not be as crazy as it sounds. In fact, it could be a very crafty tax strategy.
Few investment products provide the tax advantages of property ownership. A current favorite tax strategy is making a like-kind or deferred exchange-also known as a 1031 exchange-when selling and buying investment property. You’ve probably heard the term “1031 exchange” bantered around cocktail parties these last few years. A 1031 exchange allows you to defer paying taxes on the profit you make through the sale of an investment property as long as you use that profit to purchase another similar property within a short period of time. Well the 1031 like-kind exchange has a condemned cousin: the “1033″ or “Involuntary Conversion” exchange.
A 1033 election is similar to the 1031 but with some attractive differences. With a 1033 election you have up to 3 years in which to find a replacement property; with a 1031 you’re usually limited to 180 days. Even better, with a properly structured 1033 election you can leverage the gain of the 1033 sale. What does this mean? Well it means that you don’t have to put all of the profit you’ve made through the sale of the original property directly back into the purchase of another property. Instead, you can finance the acquisition of the replacement property and free up cash to leverage other acquisitions. Let’s say you have $10,000 in profit from the sale of a property eligible for a 1033 tax election. You finance 80% of the purchase of a replacement property priced at $10,000, take the 1033 election, and provide yourself with $8,000 in cash to invest elsewhere. Even though you’ve put only $2,000 down on the replacement property, in the eyes of the IRS, you’ve purchased a $10,000 property and met the requirements of the 1033 election.
There’s only one big hurdle: the 1033 is designed for “involuntary conversions,” that is, when your property is destroyed, stolen, or condemned; or, interestingly, under the threat of condemnation. In 2007 many people were eligible for 1033 election as a result of hurricane Katrina. The IRS provides relaxed restrictions on finding and buying a replacement property under these conditions because they don’t want to penalize you if you lost your property through no fault of your own. Of course property destroyed in a hurricane is not much good to anyone. It’s the final classification listed above that can possibly make a 1033 election useful to the right investor-when there is a threat the property will be condemned. The tax code reads:
Threat of condemnation. A threat of condemnation exists if a representative of a government body or a public official authorized to acquire property for public use informs you that the government body or official has decided to acquire your property. You must have reasonable grounds to believe that, if you do not sell voluntarily, your property will be condemned. The sale of your property to someone other than the condemning authority will also qualify as an involuntary conversion, provided you have reasonable grounds to believe that your property will be condemned. If the buyer of this property knows at the time of purchase that it will be condemned and sells it to the condemning authority, this sale also qualifies as an involuntary conversion.
Reports of condemnation. A threat of condemnation exists if you learn of a decision to acquire your property for public use through a report in a newspaper or other news medium, and this report is confirmed by a representative of the government body or public official involved. You must have reasonable grounds to believe that they will take necessary steps to condemn your property if you do not sell voluntarily. If you relied on oral statements made by a government representative or public official, the Internal Revenue Service may ask you to get written confirmation of the statements.
The IRS understands that government property condemnations can take some time, but that a property that has been identified for condemnation is as good as dead in the eyes of most owners and future buyers. Therefore, they allow you to take a 1033 election on property you sell after a government body has declared its intent to take it. A savvy investor may be able to take advantage of time between the government body’s declaration of intent to condemn and the actual condemnation.
So your sister may just have some money from the sale of an investment property sitting in the hands of some 1031 intermediary and she may need to use or lose this money within 180 days. Well, if she’s done her homework, she’s got a good accountant, she can prove that the town has made known its intentions to put a bridge across the property, and she thinks she can either resell to another savvy investor-maybe for the very same reasons she herself purchased the property-or wait until the town buys the property, she could very well pass her gain through this property, leverage those 180 days to 3 years and leverage her deferred gain for the purchase of three or four other properties.
The scenario described above is a general example, and you need to keep your eyes and ears open for a property pending condemnation-you don’t find them everyday. You will also need to talk to your accountant or tax lawyer to discuss both your specific financial situation and the best tax strategies for your specific situation.