What to Know About 1033 Exchanges and Involuntary Conversions

Section 1033 (a close cousin to 1031) allows you to defer the gain when you lose your property due to an involuntary conversion such as theft, condemnation, conversion, eminent domain takings, etc. The benefits of a 1033 exchange are that you get to defer that gain. In some ways, 1033 is better than 1031 because you have a longer period to reinvest your funds and you don’t need to use an intermediary to hold your funds.

The Downside of 1033

Here’s the downside of 1033. In order to do a 1033 you must have had an involuntary loss. Commonly this arises in the context of a condemnation proceeding started against you or knowledge of a credible threat of condemnation. The problem is that many municipalities are leery of starting an actual condemnation - they don’t want the litigation headaches. Instead they want to negotiate with the seller to come to an voluntary and mutually agreeable price. If you’re negotiating, it’s hard to say that you’re selling under threat of condemnation. So many people who are dealing with government bodies will set the transaction up under 1031 – and if it qualifies for 1031 great. As a backup they can have a 1033 to fall back on.

Get Something in Writing

Mere saber-rattling by the government authority (“well we could condemn if we wanted to…”) probably doesn’t qualify as a credible threat. So I advise people to do the 1031 exchange or get something substantive from the government entity that they will condemn. For example, if you can get them to put a representation and warranty in the purchase agreement that the government authority can and will condemn if this purchase agreement is not accepted then you’ve got something authoritative in writing that you can rely on for your 1033. Absent credible evidence that the governmental agency has the power to take the property and has in fact made an actual imminent threat to take the real property you’re better off structuring as a 1031.

Another consideration for owner-operators (owner-user), that run a business out of their condemned relinquished property is that the like-kind standard under 1033 may require them to purchase a replacement property that is “similar or related in service or use” to their old relinquished property.  This requirement under 1033 that the replacement property be functionally equivalent is a much more exacting standard than the broadly construed like-kind standard for real estate under 1031.  Rev. Rul. 64-237, 1964-2 C.B. 319, states that, with respect to an owner-user, property is not considered similar or related in service or use to the converted property unless the physical characteristics and end uses of the converted and replacement properties are closely similar.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Requirements for Taking Title to Your 1031 Exchange Replacement Property

In order to qualify for a 1031 exchange, a taxpayer must have held their old property for investment or business purposes. But how exactly can you take title to your new replacement property? There are a few methods, which we’ll explain in this article.

Basic Requirements

The basic requirement is that the same taxpayer that disposed of the old Relinquished Property should be the party to use their exchange funds to purchase the new Replacement Property and the same taxpayer should take title to the new Replacement Property.  That way there is a continuation of investment by the same taxpayer and the “exchange” is completed into the new Replacement Property.  If a different taxpayer were to receive title on the new property, then the IRS would not view that as an exchange and would not allow the taxpayer who sold the Relinquished Property to defer their gain because they would not have completed an exchange with their exchange funds.

This is a complex area of law, and it’s important to have a skilled QI on your side to make sure you have all of your bases covered during your 1031 exchange.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Is it Necessary to Assign the Purchase Agreement to Your Qualified Intermediary?

Many people ask “Why do I have to assign my purchase agreement to my Qualified Intermediary in a 1031 exchange?” And furthermore, “Why do I have to give notice to all of the other persons involved in the purchase agreement that I am assigning my contract to my intermediary.” It seems intrusive to have to give everyone notice that you are doing an exchange. Why is it anyone’s business?

Old School Requirements

Let’s go back in time before the current treasury regulations were in place. Back then we would actually deed or transfer our property to the qualified intermediary. The Intermediary acted as a straw man, so that they became the seller of the relinquished property and the purchaser of the replacement property. In other words, your Intermediary actually went into title and then participated in the transfer or the purchase of the property.

Modern 1031 Tax Techniques Allow Mere Assignment

Today, qualified intermediaries do not have to legally take title. We can accomplish the same function by simply assigning to the Intermediary our rights in the relinquished property purchase agreement, or our rights in the replacement property purchase agreement. That is deemed to be the same as if the Intermediary actually took our property from us, or received the replacement property for our benefit.

Faster, Cheaper Direct Deeding for 1031 Exchanges

The benefit here is that we do not have to deed a property. We do not have to pay for extra recording fees, and we do not have to go through all of that extra hassle of actually deeding the intermediary into the chain of title. However, the treasury regulations say that if you are going to have direct deeding, (that is, the exchangor deeds the relinquished property to the buyer, and the seller of the replacement property deeds the replacement property to the exchangor) then we have to give written notice of this assignment to the Intermediary to all of the other parties to the purchase agreement. Remember, in old common law, an assignment was never considered effective unless all of the parties to that agreement were given notice.

Why Would the IRS Adopt an Old Common Law Assignment Rule?

So why would the treasury regulations have adopted this old rule? I think it is to prevent unscrupulous folks from fabricating a 1031 exchange. They can’t say, “You know that deal that we did back last year? That was a 1031 exchange.” The way to catch them in that lie would be to say, “Well, show us where you gave written notice to the other parties of the purchase agreement." If they can’t show, well then maybe it wasn’t a 1031 from the outset.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchange Similarities & Differences Between States

Not all property qualifies for 1031 exchange treatment. In particular, Congress has said that foreign property is not like-kind to US property.

So if I have a business property in Canada or Mexico and I sell it I may be subject to taxes because I'm a US taxpayer making a gain somewhere in the world. The way that section 1031 of the Internal Revenue Code is written you are taxed on income from wherever it's derived.

Under 1031 you can defer that gain but in order to acquire a qualifying property you’d have to buy another foreign property. So a foreign to foreign exchange works but foreign to US does not work.

State Law Differences

Now let's talk about some state law differences. In some states, a mobile home may be taxed and treated as personal property, much like we think of an RV or a car. In other states, a mobile home maybe consider real estate, particularly if it's affixed or strapped down to the Earth. Water rights oftentimes are considered personal property rights in some states and in other states are real property. Crops or other things that grow in the earth may be considered personal property in some states and real estate in others. So when you’re doing a 1031 exchange you want to look closely at the type of property and whether it qualifies, and what its character is – real estate or personal property.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

What to Know About Deed & Transfer Tax In a Reverse 1031 Exchange

In a reverse 1031 exchange, the qualified intermediary forms an entity that acts as a straw man to acquire the replacement property.

Exchange Accommodation Title-Holder

That straw man is called an Exchange Accommodation Title-Holder (EAT). This EAT typically holds title to the replacement property until the old relinquished property is disposed of and then the EAT (or straw man) deeds the property to the exchangor to complete their like-kind exchange.

The sad situation is that the Exchange Accommodation Title-Holders already paid deed tax once when it received the parked property from the seller and now is being subjected to transfer tax again when the replacement property is deeded to the exchangor.

State Differences

Some states are very aggressive in taxing the transfer of the parked replacement property to the exchangor in what’s called deed tax or transfer tax. Not all states are as aggressive as say Pennsylvania or Wisconsin in collecting deed tax from the intermediaries entity to the exchangor.

In Minnesota, the Minnesota Department of Revenue has been much more accommodating in limiting the transfer tax to the value of the exchange services provided by the exchange accommodation title holder. Other states are imposing the transfer tax on the entire value of the property being conveyed.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved