Tax Friendly Provisions for Rental Property Owners

A case study in leveraging Section 1033 and 1031

Recently, a residential rental property owned by one of our clients was destroyed by fire. The house was a total loss. The tax basis in the house was $150,000, and our client will receive insurance proceeds on the house in the amount of $500,000.

Our client decided not to rebuild the house and is looking for ways to acquire another rental property in a more suitable location. They received and accepted an offer to sell the lot for $400,000. The tax basis of the lot is $200,000.

Tax challenge

Our client would like to use the insurance proceeds from the house and the proceeds from the sale of the property to acquire the new rental property without paying tax on the insurance proceeds or on the proceeds from the sale of the lot.

Tax savings opportunity

Our client can accomplish their desired outcome by using the taxpayer-friendly provision of IRC Section 1031 dealing with exchanges of real estate and Section 1033 dealing with involuntary conversion of real estate.

Step 1: Leverage Section 1033

The destruction of the residence by the fire is considered an involuntary conversion that is covered under IRC Section 1033. The receipt of the insurance proceeds from the fire produces a realized gain of $350,000. However, under the provision of Section 1033 the gain is deferred if the taxpayer invests in a suitable replacement property.

Suitable replacement property under Section 1033 means property similar to or related use to the property destroyed by fire.  As a result, in order to qualify for deferral of the gain under Section 1033, the taxpayer would have to reinvest in another residential rental property. The replacement property does not have to be located in the same location or city; it can be located in another city and satisfy the rules of Section 1033.

There is a special timing rule under Section 1033. In order to defer the gain from the insurance proceeds, the replacement property must be acquired within two years after the close of tax year in which the gain occurred. So, for example, if the insurance proceeds from the fire were received in 2023, the replacement property must be acquired by December 31,2025, in order to defer the gain under Section 1033.

In addition, the taxpayer would have to reinvest $500,000 in the replacement property to defer the total gain under Section 1033. There is no requirement under Section 1033 that the taxpayer use the actual insurance proceeds to make the reinvestment.  The taxpayer can save the insurance proceeds and use debt financing in order to acquire the replacement property. Alternatively, if there was debt on the property, the insurance proceeds can be used to reduce the debt on the rental property.

As mentioned above, Section 1033 defers the gain on the involuntary conversion. The tax basis of the replacement property is reduced by the amount of the deferred gain. So, the gain would be subject to tax on a subsequent sale at whatever tax rates are in effect at that time.

Step 2: Leverage Section 1031 – Deferral of gain on the sale of the lot

If the sale of the lot is properly structured, the gain on the lot sale can be deferred under the Like-Kind exchange provisions of Section 1031. The lot meets the definition or real property used in a trade or business (rental) or held for investment. The tax from the sale can be deferred if the proceeds are reinvested into other real estate used in a trade or business or real estate held for investment.  The like-kind rules of Section 1031 are not as stringent as the replacement property rules contained in Section 1033.

For example, the proceeds from the sale of the lot could be re-invested into an office building or farmland and satisfy the replacement property rules of Section 1031.

The reinvestment of the proceeds from the lot sale does not have to occur at the same time as the sale of the lot. The regulations under Section 1031 allow for gain deferral using deferred exchanges. In order to accomplish a deferred exchange under Section 1031, the taxpayer must use a qualified intermediary to receive the sales proceeds and make the reinvestment. Replacement property must be identified within 45 days of sale, and the purchase of the replacement property must occur within 180 days of the first sale, or the due date of the tax return for the year of sale, if earlier. The due date of the tax return includes extensions.

If the lot is secured by debt, this can complicate the 1031 exchange process. The replacement property would have to be subject to the same amount of debt that the relinquished property was subject to prior to sale.

Like Section 1033, Section 1031 only defers the gain on the sale of the lot. The tax basis of the replacement property is reduced by the gain deferred in the like kind exchange.

Result

Using the taxpayer friendly provisions of Sections 1031 and 1033, the taxpayer could convert his existing rental property into multiple properties in different locations.

Application of Section 1031 and 1033 can be complex. This case study serves as a general overview of the two IRC sections. You should consult a tax professional for advice on the best approach for your unique situation. If you have questions on this or other tax considerations specific to you and your real estate business, please contact your Keiter Opportunity Advisor. Email | Call: 804.747.0000.