For high income earners and high net worth investors, commercial real estate is a particularly attractive asset class for investment. This is because it offers a mix of the chance for significant price appreciation, regular income, and significant tax benefits. Among the most enticing tax benefits is the ability to defer capital gains taxes on the profitable sale of an asset and the ability to exchange one property for another in the event of a condemnation or natural disaster.
In this article, we are going to compare and contrast both of these transaction types known as a 1031 Exchange and a 1033 Exchange, respectively. For each, we will describe what they are and how they work. In addition, we will describe the key differences between the two. By the end, readers will have the information needed to determine which of these transaction types is the most suitable fit for their own needs.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. In our line of business, we frequently work with investors who are looking to complete a 1031 Exchange and have developed a deep knowledge base in this area. If you are an Accredited Investor looking to learn more about 1031 Exchange investment opportunities, click here.
A Brief Explanation of 1031 Exchanges
A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of a property as long as they reinvest the sales proceeds into another “like kind property.” The logistics of the transaction can be tricky, but they typically work like this:
- An investor, with a large potential gain on a property, determines that they would like to sell it. For example, this could be a husband and wife who have owned a small retail center for 20 years where, upon sale, they would realize a significant profit.
- Once the property is identified, it is listed for sale and sold. In 1031 Exchange parlance, this is known as the “Relinquished Property.”
- Once the property is sold, the real estate investor has 45 days to identify a new property to purchase. This is known as the “Replacement Property” and it must be “like kind” to the Relinquished Property. In general, all commercial real estate investment property is considered to be like kind to other commercial property as long as it is held for “productive use in a trade” or held for investment.
- Once identified, investors have 180 days from the sale of the Relinquished Property to close on the purchase of the replacement property. Under the rules of the exchange, investors must invest all of the gain in the new property. If they realize any of it, it may be considered to be “boot” and it is taxable.
When the transaction is completed, investors can defer taxes on the gain indefinitely. In addition, they can complete a 1031 Exchange over and over, allowing their money to grow tax free over a long period of time.
A complete set of rules for completing a 1031 Exchange are outlined in section 1031 of the Internal Revenue Code and they must be followed closely to receive full tax deferral. To make sure the exchange rules are followed, it is a best practice for individuals to work with a Qualified Intermediary who is a 1031 expert and whose job it is to work with investors to facilitate a smooth transaction.
Clearly, the tax benefits of this type of transaction are significant so it is no surprise that they are popular with individual investors. But, it isn’t the only type of exchange transaction available. There is another, lesser known type, that also offers compelling benefits. It is the 1033 Exchange.
A Brief Explanation of 1033 Exchanges
A 1033 Exchange is a real estate transaction that allows investors to defer capital gains taxes when they realize a gain from an “involuntary conversion” of the property for cash. Potential reasons for an involuntary conversion include:
- The property is destroyed due to a natural disaster,
- The property is lost or seized through the eminent domain process
- The property is transferred because it was condemned
In each of the above scenarios, the property is not necessarily “sold”, but the property owner may experience a gain due to compensation received from an insurance company (natural disaster) or government (eminent domain). If the compensation received is greater than the cost basis on the property, the owner may have a taxable gain. But, they can defer taxes as long as they reinvest the proceeds into a qualified replacement property. In this sense, it is very similar to a 1031 Exchange, but a 1033 Exchange comes with its own set of rules. They include:
- The exchange must be made only as the result of the destruction or seizure of a property
- The new property’s title must be held by the same individual or entity that held title to the property that was destroyed, seized, or condemned
- The cost of the new property must be equal to or greater than the net proceeds received. In addition, the debt on the new property must be equal to or greater than the debt on the old property.
- The new property must have a “similar or related” use to the converted property. Specifically, this means that the two properties must be physically similar and used for a similar purpose. In addition, the new property cannot alter the character of the investment.
- The replacement period is two years, which begins at the end of the first year that the gain is realized. If the property was condemned, the replacement period is extended to three years. Or, if the new property is located in a disaster area, the replacement period is extended to four years.
- Proceeds can be given directly to owners/investors.
The specific rules for a 1033 Exchange are codified in section 1033 of the Internal Revenue Code (IRC) so investors should read/review them carefully before entering into this type of transaction.
With these two types of exchanges identified, it can be helpful to directly contrast key differences between them.
1031 and 1033 Exchanges Compared
For investors potentially considering choosing between one of these two types of exchanges, a direct comparison is made below.
In a 1031 Exchange, the value of the debt in the Replacement Property must be equal to or greater than the value of the debt in the Relinquished Property.
In a 1033 Exchange, the value of the debt on the “Converted Property” must be equal to or greater than the value of the debt that was relieved when the proceeds were received.
A Qualified Intermediary is an individual or firm who has specific expertise to help facilitate a transaction. Using them is a best practice in a 1031 Exchange.
In a 1033 Exchange, a Qualified Intermediary is not typically used.
In a 1031 Exchange, proceeds from the sale of the Relinquished Property must be reinvested into another property known as the “Replacement Property.”
There is also a Replacement Property property in a 1033 Exchange. It is the one that is purchased with the condemnation proceeds, insurance payout, or funds received from the eminent domain transfer.
In a 1031 Exchange, the timelines are clear. The investor/taxpayer must first identify their replacement property within 45 days of the sale of the relinquished property. In addition, the purchase of the replacement property must be closed within 180 days of the sale date of the relinquished property.
In a 1033 Exchange, the timelines are much more generous. In general, the replacement period is two years, which begins at the end of the first year that the gain is realized. However, if the property was condemned, the replacement period is extended to three years. Or, if the new property is located in a disaster area, the replacement period is extended to four years.
Exchange Period and Identification Period
As described in the previous section, the exchange periods and identification periods for these two types of exchanges can be significantly different.
In a 1031 Exchange, investors must identify a suitable replacement property within 45 days of the sale of their relinquished property. They must close on the purchase of it within 180 days.
In a 1033 Exchange, the time frame for the deployment of exchange funds is much less restrictive. The replacement period begins at the end of the first year that the gain is realized. But, if the property was condemned, the replacement period increases to three years. If the property is located in a disaster area, the replacement period is extended to four years.
When to Perform a 1031 Exchange vs. a 1033 Exchange
Every transaction is unique so it is always important to carefully review the profile of the deal and to consult with a tax advisor or CPA about the potential tax liability that may or may not result from completing an IRC section 1031 Exchange or a 1033 Exchange.
In general, a 1031, Like Kind Exchange is most suitable when an investor has sold or plans to sell a property where they will experience a capital gain and they want to continue investing in future properties. The key point here is that the property is voluntarily sold. For example, the investor may want to take advantage of a hot market or they may need to make a sale for estate planning purposes.
In a 1033 Exchange, the decision about when to relinquish the property may not be up to the owner. For example, there may be a forced sale due to a seizure by eminent domain or the property owner may receive compensation due to destruction in a natural disaster. In this case, the 1033 Exchange is likely the more suitable option.
Again, it is always a good idea to seek tax or legal advice to determine which type is most suitable for your unique needs.
Benefits of Each Exchange Type
The key benefit with each of these exchange types is tax deferment or “non-recognition of a gain.” This aside, there are a number of benefits that are unique to each of these exchange types
1031 Exchange Benefits
Aside from the tax deferral, there are three other notable benefits of a 1031 Exchange:
- Diversification: 1031 Exchange investors have the ability to exchange one property for several as long as they comply with the rules outlined by the internal revenue code. This allows investors to diversify their holdings, which can be important in times of economic distress.
- Bigger Properties: By allowing their capital to grow tax deferred, investors can exchange into larger properties, which can give a portfolio scale. This could lead to increased income over time.
- Passive Income: In many cases, some of the most popular 1031 Exchange replacement properties options are those with just one or two tenants who are on triple net leases – which means that the tenant is responsible for the cost and effort associated with the daily upkeep of the property. These types of triple net leased properties can produce a nice stream of passive income.
1033 Exchange Benefits
Likewise, there are three notable benefits (aside from tax deferral) for completing a 1033 Exchange:
- Tax Free Proceeds: 1033 investors do not have to reinvest all of their proceeds, plus debt, into another, like kind property. They are only required to reinvest the value of the relinquished property. Thus, it is possible they can get tax free cash out of the deal. For example, suppose an investor relinquishes a $1MM property that had a loan balance of $500,000. They could buy another property for $1MM, but do not have to maintain the same level of debt. If they got a $750,000 loan, they could walk away from the transaction with $250,000 in tax free cash proceeds.
- Qualified Intermediary: 1033 Exchange investors do not need to use a Qualified Intermediary to complete the exchange process. For this reason, it may be simpler and less expensive.
- Short Term Reinvestment: 1033 Exchange investors have a much more generous timeline to complete their exchange – up to four years in some cases. As a result, investors are allowed to reinvest their funds in the interim period between when they relinquish their property and purchase its replacement.
Investing Through a Real Estate Syndication & These Exchange Types
As this article makes clear, there are a lot of rules and nuances to completing each of these exchange transactions. They can be tricky and difficult for individual investors to follow and, if they don’t, the consequences can be costly.
For this reason, many investors choose to invest in a real estate syndication as their replacement property option in both exchange types. The key benefit here is that the syndicator does all of the hard work of finding, financing, and managing the property while investors just need to contribute their own capital and collect their share of the income and profits produced by the underlying property.
Summary of 1031 vs 1033 Exchanges
1031 and 1033 Exchanges are both types of real estate transactions that allow investors to defer capital gains taxes as long as they follow a series of rules laid out by the Internal Revenue Service.
In a 1031 Exchange, investors can defer capital gains taxes from the profitable sale of a real property as long as they reinvest the sale proceeds into another property that is considered to be “like kind.”
In a 1033 Exchange, investors can defer capital gains taxes on the sale or transfer of a property due to seizure by eminent domain or destruction by natural disaster.
While the key benefit of both of these transactions is the deferral of capital gains taxes, there are a number of key differences that investors should identify and evaluate before choosing which of these options is the right fit for their own needs.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.