§1033 and Tax-Free Conversion Proceeds
One of the most powerful provisions of §1033 is the ability to replace equity in the converted property with new debt on the replacement property, a transaction strictly prohibited by §1031. By increasing the debt, the “equal and up” replacement requirement can be accomplished with less reinvestment of the conversion proceeds. This process also creates an opportunity for a refund if the tax has already been paid.
Example 1: Gain not reported
In May of 2016, an investor had rental property taken through the process of eminent domain, receiving compensation of $1,000,000 in October 2016. An election for nonrecognition under Section 1033 is made on the 2016 tax return. §1033(a)-2(A) requires the property owner, by December 31, 2019, to purchase qualifying replacement property valued at $1,000,000 or more for full tax deferral.
In February of 2018, the investor purchased beneficial interests in a Delaware Statutory Trust. The trust acquired a 300 unit luxury apartment complex with 47% cash and a mortgage of 53%, a loan-to-value (LTV) of 53%. By investing $470,000 of equity and adding $530,000 of new, non-recourse financing, the property owner has purchased replacement real estate valued at $1,000,000, fulfilling the requirement of §1033(a)-2(A), resulting in full deferral of the gain. The remaining proceeds of $530,000 need not be reinvested in replacement property, and is completely tax free
to the owner.
Highly leveraged DSTs (75%-80% LTV) have been structured for this purpose, as well as other advanced exchange techniques. In the scenario above, $750,000 to $800,000 would be retained in cash, free of tax by investing $200,000 to $250,000 of the $1,000,000 award
Example 2: Gain reported
In May of 2016, an investor had rental property taken through the process of eminent domain, receiving compensation of $1,000,000 in October 2016. Gain was reported and paid in April of 2017.
In 2018 (still within the replacement period), a DST holding title to 16 brand-name stores with a loan-to-value of 78% is purchased as qualified replacement property and designated as such on the 2018 return. By investing $220,000 of equity and adding $780,000 of new, non-recourse financing, the property owner has purchased replacement real estate valued at $1,000,000, fulfilling the requirement of §1033(a)-2(A).
Pursuant to IRC §6511, the property owner can, until April of 2020, file a claim for refund of 2016 taxes paid (three years from the due date of the 2016 return). In the scenario above, the property owner can receive a refund of the tax paid in 2017, and retain the remainder of the proceeds not invested in the replacement property - tax free.
While replacement property and financing can be secured personally by the owner, DSTs facilitate the process as the debt is already in place without the need for lender approval. Due diligence has already been completed, and closings can take place in a matter of days. In addition, DSTs historically have benefitted from lower, institutional interest rates that may be unavailable to the public markets.