Replacing Property after Disasters: Deadline Extensions and Rules to Know
Did Hurricane Matthew damage any of your property or delay a real estate deal? Specifically, were you planning on taking the gains you made from selling one piece of property and investing that money in another property so you could defer the taxes on your gains?
Or, do you need to replace property as a direct result of the storm?
Well, there may still be a bright spot for you in the wake of this latest East Coast disaster.
The usual deadlines to complete 1031 exchanges (also known as like-kind exchanges) are being extended because of Hurricane Matthew. If the property you were about to buy or sell was located in a federally declared disaster area, and it was damaged or destroyed or your closing was delayed, you will have extra time to choose a new property, renegotiate or reschedule your closing.
Deadlines for completing 1033 exchanges (commonly known as involuntary conversions) have been affected, too. So if your property was involuntarily converted in a prior year and Hurricane Matthew kept you from buying replacement property in time, you have an extension of time to reinvest the money you received.
All this can affect whether or not you’re able to defer gain – and ultimately how much money you’re left with at the end of the day.
What Is a 1031 Exchange – and What Can It Do for You?
A 1031 exchange (or like-kind exchange) is named for the section of tax code it’s found under: Section 1031.
A 1031 exchange happens when you take the gains you made from the sale of property and put those gains into the purchase of another property that is of a “like kind” – thus, the name “like-kind exchange.” When you re-invest the sale proceeds into another property, you get to defer the taxes on your gain until the replacement property you bought is sold.
However, it isn’t easy to get this treatment. The first hurdle is that you can only get deferral under the like-kind exchange rules if the property sold was held for investment or was used in a trade or business. So, you can’t use this special rule to help you get a larger home or a boat you use with the family on weekends. Two other hurdles are right in the name – the “exchange” hurdle and the “like-kind” hurdle.
The word “exchange” is key to 1031 exchange treatment. You cannot defer your gain if you take control of cash or other assets prior to closing on the replacement property. Even control by relatives, employees and certain entities (and even attorneys or accountants whom you regularly employ) can be treated as though you got the cash. Because many details need to be correct to make sure a like-kind exchange qualifies for tax deferral, businesses referred to as qualified intermediaries are normally used to hold the money received on the sale of your original property.
Another key to deferral is that the replacement property must be of a “like-kind” to the property that was sold. Some examples of qualifying exchanges are:
- Raw land held for investment in exchange for a building held for rental
- Rental home in Florida in exchange for rental condominium in the Bahamas
- Farm land used to grow crops in exchange for a silo used to store crops once they are harvested
- One airplane used to provide flying lessons to customers in exchange for another airplane used to provide flying lessons to customers
- A painting in exchange for a sculpture, if both are held for investment purposes
What Is an Involuntary Conversion – And How Can You Defer Gain?
An involuntary conversion happens when property you own is taken from you or destroyed against your will. The most common causes of an involuntary conversion are natural disaster (such as Hurricane Matthew), theft or seizure by the government.
If you suffer an involuntary conversion, you might get compensated for your economic loss in the form of insurance proceeds or an eminent domain award from the government. If the amount you receive is more than your tax basis in the property, you could find yourself with a gain for tax purposes (even if you do not believe that you were made whole with respect to the value).
Sometimes you may be able to defer gain on an involuntary conversion using a like-kind exchange. However, it doesn’t always work out that way. Sometimes it takes too long to receive compensation, so you cannot meet the strict timing requirements of IRC Section 1031. Other times, the insurance company won’t give the money to anyone but you. And sometimes you don’t meet another requirement, such as identifying the replacement property or closing on the purchase within the permitted time. If you have one of these problems, you may be able to defer your gain by completing an exchange that qualifies under IRC Section 1033.
In some ways, it is easier to defer gain under the involuntary conversion rules than under the like-kind exchange rules. That’s because you don’t need a qualified intermediary, you can hold (and even use) the cash you receive before purchasing the replacement property, and you have a longer period of time to close on your replacement property.
However, the types of property that qualify as replacement property are more restricted than the types that qualify under the 1031 exchange rules. In order for gain to be deferred under these rules, the replacement property must be similar or related in service or use to the old property. Under these criteria, raw land and improved real estate are generally not considered to be similar in use. Neither are a painting and a sculpture.
Some examples of exchanges that would be considered similar in use under Section 1033 are:
- A commercial building and an apartment building, if both are held for rental
- One building used in manufacturing operations replaced with two buildings that house the manufacturing operations
- Land held for sale and other land held for sale
- Farm land held and operated directly exchanged for all the stock of a corporation that owns and operates farm land
Changes and Extensions to Timelines
Normally, when taking advantage of 1031 exchanges, two requirements must be met. First, a replacement property must be identified by midnight of the 45th calendar day after you have sold or transferred the property.
Second, the replacement property must be closed on and delivered to you by either the 180th day after you sold or transferred your first property or by the due date (including extensions) of your income tax return for the taxable year in which you sold your first property, whichever one comes earlier. A purchase of replacement property before you sell your old property can be accommodated, but special arrangements known as qualified exchange accommodation agreements (“QEAA”) have to be completed within five business days after you purchase the replacement property.
Replacement property for an involuntary conversion must generally be purchased within two years after the end of the tax year in which gain is first realized. In the case of a federally declared disaster, you get an extra two years to close on your replacement property.
Normally, these timelines set hard-and-fast deadlines. Missing them would mean that you have to recognize gain even if it were physically impossible for you to complete the closing. Some of the more common ways Hurricane Matthew could have kept you from completing an exchange on time are:
- Your attorney or bank was not able to complete a closing because of the storm
- A lender pulled out of the area (either temporarily or permanently)
- Your identified replacement property was destroyed
However, Rev. Proc. 2007-56 provides extra time to complete several time-sensitive acts, including like-kind exchanges, if you were affected by a presidentially declared disaster. Thanks to this procedure and certain IRS Notices that have been issued regarding Hurricane Matthew, you may be able to postpone the 45-day and 180-day deadlines for 1031 exchanges and the two- and four-year deadlines for 1033 exchanges by 120 days or until March 15, 2017, whichever is later. (If you’re using the date of your tax return as your deadline, that date cannot be postponed.) The five-business day period for entering into a QEAA can be extended, as well.
BONUS TIP: If you begin a 1031 exchange towards the end of the calendar year, your 180-day deadline for completing the exchange could fall in the following year. Timing is important, because the sale and replacement of your property have to be reported on the same tax return. Therefore, you should wait to file your tax return until your 1031 exchange has been completed and all the properties involved have changed hands. You can file for an extension to your tax return deadline, if necessary, to allow time for the exchange to be completed.
Ultimate Takeaways and Reminders
Like-kind exchanges can help anyone who sells property defer the taxes on their gains and invest in more property, as can reinvesting money received from an involuntary conversion. But qualifying for the deferrals isn’t easy, and dealing with hurricane recovery only makes it harder. These deadline extensions can make recovering your losses a little easier by giving you more time to find replacement property and seal the deal.
If you lost property during the storm and plan to reinvest any compensation you receive, make sure you consider investing in similar-use property, so you can take advantage of the deferrals available for involuntary conversions.
And because income is deferred, remember your basis in the replacement property will be reduced by any gain not recognized.
If you’re thinking of relocating your business as you rebuild from the storm, remember that many states, counties and cities offer incentives for businesses that relocate and bring jobs to their residents. But, these incentives need to be negotiated in advance.
Action Steps – What Category Are You In?
1031 Exchanges, 1033 Exchanges, Deferring Your Gain
Do you have questions about how to take advantage of 1031 exchanges, how to defer gain from involuntary conversions, or what kind of extensions you could get if you’re in a disaster area? Contact Deborah McDonough in the Real Estate and Construction group at Cherry Bekaert with your questions. She and her group are a great resource to tap into when you need answers to higher-level real estate questions.
Maximizing Credits and Deductions When You Replace Property
Could you use some help identifying the tax savings you qualify for when you purchase replacement property? Could your replacement property or any of your repairs qualify for energy credits or accelerated cost recovery, including bonus depreciation? Start with a call to the Cherry Bekaert Accounting Methods team for clear answers to what’s available for your personal situation.
Relocating after Disaster
If you are relocating your business after the storm, reach out to Anne Yancey, Director of State Credits and Incentives. She’s made a career out of negotiating benefits for clients – definitely someone you want on your side at the bargaining table.
Reach out to Your Local Rep
Maybe reaching out to your local client service professionals will be the right choice for you. They can guide you as you deal with these rules and other questions you might have related to this storm or any major loss, such as how and when to report insurance proceeds or claim a tax deduction for losses to your property’s value. They can even show you how to use money from your retirement plan to help with your recovery efforts.
If you were directly impacted by Hurricane Matthew, check out this list of disaster recovery resources for your state. The list includes links to the IRS notices that identify the designated disaster areas that qualify for extra time to complete your exchange. It also includes different state and federal government resources that can help you get the information you need – so you can hopefully recover your losses and get back to normal sooner.