The Exchange Update
A Newsletter For 1031 Tax-Deferred Exchanges
Deferring Gain on Condemned Property
Internal Revenue Code Section 1033 provides that gain that is realized from an “involuntary conversion” can be deferred if the owner acquires replacement property that is similar to the property that was lost. In most respects, the 1033 exchange rules are easier to comply with than those regarding a 1031 exchange, but there are still limitations on which properties qualify as “similar” properties and when those properties must be acquired.
IRC Section 1033 allows an owner to defer tax that might otherwise be due if there is an “involuntary conversion.” An involuntary conversion includes:
- Property that is destroyed because of a casualty;
- Property that is lost because of theft; and
- Property that is transferred because of a condemnation or threat of condemnation.
Unlike a 1031 exchange, an owner whose property is converted can hold the proceeds until he acquires replacement property, and no intermediary is required. The owner does not have to be concerned about complying with identification rules, although the replacement property is identified on the owner’s tax return. The time frame for closing on the replacement property is two years or longer, as discussed below, and the taxpayer can apply for an extension of that time frame in some cases.
The taxpayer must acquire the replacement property during the “replacement period” which is:
- DAY 1 OF REPLACEMENT PERIOD: The first day of the replacement period is the earlier of the date of the casualty or condemnation, or the earliest date on which the threat of condemnation occurred.
- LAST DAY OF REPLACEMENT PERIOD: 2 years (or longer, see below*) after the end of the first tax year when any part of the gain is realized by the taxpayer. The taxpayer should check with his tax advisor to determine when the gain is first realized.
In a 1033 exchange, the replacement property must be “similar or related in service or use” to the converted property. In most cases, this standard is more restrictive than the like kind standard under IRC 1031. For example, the IRS has held that a billiard center is not similar or related in service or use to a bowling center, and that property used for an owner’s business is not similar to rental property.
There is an alternative standard for replacement property, but only if (a) the converted property is real property and was held for productive use in a trade or business or for investment, and (b) the conversion was due to a condemnation or threat of condemnation. In this case, the replacement property qualifies if it is “like kind” to the converted property. This is an optional standard that the taxpayer can elect to use, and the term “like kind” means the same thing as like kind under IRC Section 1031. In most, but not all cases, it is easier to comply with the “like kind” standard than the “similar or related in service or use” standard.
A 1033 exchange is a useful tool to defer tax when a taxpayer loses property because of a casualty or condemnation. These are some of the basic rules, but owners who are contemplating a 1033 exchange should investigate the details further with their tax advisors. First American Exchange is always available to answer your questions and to help you set up the other, more common tax deferred exchange, based on Internal Revenue Code Section 1031.
The decline in residential development has provided an unexpected opportunity for land preservation. Large tracks of land that were slated for new homes are now being sold in whole or in part to local and regional municipalities and open space organizations. Certainly the sale of the entire fee interest in the land would likely qualify for a 1031 exchange; however, the sale of less than a fee interest may also qualify for a 1031 exchange if certain criteria are met.
The IRS has issued several private letter rulings finding that certain types of conservation and agricultural easements are like kind to real estate. A conservation easement is a voluntary agreement that allows a landowner to limit the type or amount of development on their property while retaining private ownership of the land. Generally, the easement needs to be perpetual in nature and considered an interest in real estate for state law purposes.
This position was affirmed fairly recently in PLR 200649028 when the IRS held that a stewardship easement was like kind to a fee interest in real estate. The IRS based its decision on the fact that the stewardship easement was considered an interest in real property under state law and that the easement was perpetual. The ruling also discussed that the sale of the easement significantly and permanently restricted the future use of the taxpayer’s property such that the fair market value of the property, if sold, would be impaired. The transaction discussed in this PLR was somewhat unique in its structure. First, the taxpayer conveyed the relinquished property by granting the county a perpetual restrictive stewardship easement over ranch land in return for a certain amount of stewardship credits. The value of the credits was equal to the value of the property rights that the taxpayer permanently relinquished to the county. During the exchange period, the taxpayer converted the credits to cash by selling them to a third party buyer. The cash was then used to purchase the replacement property. The taxpayer was never in receipt of the credits or the relinquished property proceeds during the exchange period. The IRS held that this structure did not disqualify the transaction from 1031 tax deferral treatment.
In summary, a 1031 exchange opens many investment opportunities for land owners who wish to exchange conservation easements for any other real property.