Though necessary to accommodate the “public good”, privately owned properties are often acquired through legal condemnation or are requisitioned through a governmental exertion of “eminent domain”. These are properties located in the way of civic works projects, like light rail, schools and roadway expansions. When this action is taken, property owners are forced to sell. This often provokes a tax liability as the property owner is then taxed on capital gains and depreciation recapture resulting from the proceeds paid for the relinquishment of their property.
Property owners need to be aware that if one’s property is facing condemnation or requisition through eminent domain, they may be able to defer paying taxes on any resulting gains by conducting a 1033 exchange, replacing one’s condemned property with another real estate investment.
Similar to the 1031 exchange, which is a section of the Federal Tax Code, Section 1033 also provides for the tax-deferred exchange into other real estate holdings. This section of the Internal Revenue Code allows property owners to defer taxes by replacing their condemned (relinquished) property by investing the proceeds from the property’s sale.
1033 exchanges are done in cases where the condemnation, destruction, or other “conversion” of the property is involuntary, such as in right-of-way, infrastructure or through government condemnation for schools, sports arenas and parks. There are major differences between 1033 and 1031 exchanges that are imperative for property owners to understand, particularly regarding the replacement property, the timeframe that the property must be replaced in, and the parties involved in the exchange.
When governmental agencies seek to acquire property through the exercising of their power of eminent domain, they are legally obligated to compensate property owners for the owner’s property value. This value is determined based on its “highest and best use”. For example, a condemned property zoned for commercial use that was not being used as such would be valued as if it were. If facing condemnation or requisition, it is wise to seek out the advice of an eminent domain attorney to ensure you receive the highest price for your property.
It is important to note that the 1033 exchanger, the owner, of the condemned property will take direct receipt of the capital proceeds from their relinquished property without engaging a qualified intermediary, as is required in a 1031 exchange. As always, a CPA should be consulted to verify the exchange is in order.
For a 1033 exchange, both property held for business or investment purposes, and property used for personal enjoyment or residency that are involuntarily condemnation must be replaced within two years after the tax year in which any of the conversion gain is realized. Property owners are allowed to 1033 exchange into a replacement property that is “like-kind,” meaning any real property held for investment or business purposes. This gives investment property owners whose properties are to be condemned time to reposition their assets by acquiring other replacement investment property that meets their objectives, while deferring taxes.