Tax-Free Conversion Proceeds

§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.

Examples are for hypothetical purposes only and actual properties and results will vary. DST properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last two years, and reasonably expects the same for the current year) and accredited entities only. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). Fortitude Investment Group is independent of CIS, CAM and CIA.