Like-Kind Exchanges (1031 and 1033)
Gain or loss realized from the sale or other disposition of property must generally be recognized.
When a property owner grants a pipeline company rights to use property or a company obtains those rights through condemnation, determining the tax effects requires a careful analysis of the terms of the transaction. The transaction alternately can be treated for tax purposes as a sale of land, a sale of an easement, or a lease of or license to use land. In addition, a typical transaction may include payments to the property owner for damages to easement land or to land retained by the property owner, which are treated differently for tax purposes.
Multiple opportunities to defer gain exist. Allocation of the proceeds from the transaction between payments for the easement and payments for damages is critical to lessen tax. Where the property owner can substantiate severance damages, opportunities to offset basis against the retained property exist. The property owner also can offset payments for damages to real property resulting in the ordinary course of easement construction against basis. Two Internal Revenue Code sections (§1031 and §1033) can help taxpayers defer the recognition of gains if they are interested in reinvesting by purchasing like-kind property. A voluntary conveyance of an easement may qualify for elective deferral of gain under Sec. 1031, and a conveyance made as a result of condemnation proceedings may qualify for elective deferral of gain under Sec. 1033.
What is Like-Kind Property?
Qualifying property is that which is ‘similar or related in service or use’. Like-kind property is property of the same nature, character or class.
What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like-kind to be used either for productive use in a trade or business or for investment.
Exchanges are the sale of an investment or business use asset followed by the acquisition of another within 180 days and linked together by paperwork. The seller must not take possession of the money. Therefore, an intermediary is used to facilitate this transaction.
If you have an interest in purchasing additional property with the proceeds of a mineral sale or pipeline related transaction, contact your CPA about the 1031 process.
Example of a recent successful 1031 transaction for a mineral owner. Client owned several mineral tracts and decided to sell a tract to diversify his investment portfolio. Client wanted to purchase a commercial office building. Using a 1031 intermediary to facilitate the transaction, the seller was able to offset 100% of the gain associated with the mineral sale and use the proceeds to purchase an office building. Proper tax planning resulted in the client having a zero tax bill for the mineral sale and a new investment property, but you have to do it the right way. Contact your CPA to explore this opportunity before you sign anything.
Example of 1031 transaction. Client called Yourkovich & Associates and was negotiating a pipeline agreement. We discussed clients’ basis in the property, potential damage payments, right of way payments and the tax consequence of receiving this money. We also discussed the ability of purchasing other property before the client accepted the pipeline check. Using a 1031 exchange facilitator, the client purchased retirement property in Florida. By properly structuring the transaction, we were able to postpone $450,000 in capital gain income with the purchase of the FL property and saved $140,000 in taxes. Now instead of looking at a swath of property with missing trees, the client will be enjoying the view of coastal Florida and sunshine while realizing they saved over 30% on the purchase of their new retirement property.
What is a 1033 Exchange?
Section 1033 of the Internal Revenue Code allows gain realized from certain involuntary conversions of property to be recognized or deferred at the taxpayer's election. Under Section 1033, an involuntary conversion is defined as a destruction or loss of the property through casualty, theft or condemnation action pursuant to government powers of eminent domain, and the resulting compensation from such destruction or condemnation.
Even though the sale and/or compensation for the property were essentially forced on the taxpayer, the taxpayer is still liable for any capital gain tax liability on the compensation received. However, if the property is subject to an “involuntary conversion”, the taxpayer has the ability to defer the payment of the depreciation recapture and capital gain taxes on the involuntary conversion under the non-recognition provisions of Section 1033.
A taxpayer can postpone any realized gain to the extent that the taxpayer reinvests the compensation for conversion into replacement property. There are two real qualifications the taxpayer must meet to be eligible for non-recognition of gain under Section 1033. First, the replacement property must be replaced with like-kind property. Second, the replacement property must be purchased within the replacement period to qualify for the tax deferral, which ends after the following number of years after the tax year of the conversion:
- personal-use property, 2 years;
- business investment property:
- 2 years for the destruction or theft of the property;
- 3 years for condemnation of the property; (eminent domain)
- a residence destroyed by a disaster in a federally declared disaster area, 4 years
Example of 1033 transaction. Gas Company wanted to put a transmission pipeline through client’s property. Gas Company threatens eminent domain and sued for easement rights. Client settled a grant for easement for a large sum of money and paid taxes on the sale. IRC 1033 allows three years from the end of the condemnation year to exchange the property to defer the recognized gains. Client purchased retirement property in the Caribbean within the required time frame. We amended the gain year return to refund overpaid taxes on the deferrable gain due to the qualifying purchase. Contact your CPA to explore this opportunity.
Tax planning with the sound advice of a competent CPA and qualified attorney both before and after a property transaction can reduce or eliminate potential tax costs. Consult a CPA for additional assistance with Like-Kind Exchanges.