Your 1031 Exchange Replacement property can sometimes qualify for Section 1033 treatment; however, your replacement property must be similar or related in service or use to the property it replaces.
For real estate used in your business (including rental income property) or held for investment, a special “like-kind” rule applies. It only applies to real estate converted as a result of actual or threatened condemnation and is discussed later, after our discussion of similar or related in service or use.
If the property is converted directly into property similar or related in service or use, nonrecognition of gain is mandatory. For example, you exchange the property for qualified property of like-kind and qualify under Section 1031 for nonrecognition of gain.
Paying off or reducing a mortgage indebtedness on business property with condemnation proceeds from adjacent business property is not a qualifying expenditure under Section 1033 rules.
Similar in Service or Use
The meaning of similar in service or use depends on whether you are an owner-user or owner-investor of the property.
If you are an owner-user, similar in service or use means the replacement property must function in the same way as the property it replaces. The IRS takes an extremely narrow view of the similar use requirement. It doesn’t consider property similar or related in service or use unless the physical characteristics and the end uses of the two properties are closely similar. For example, owner-users of a manufacturing plant must reinvest in a replacement property having the same end use – another manufacturing plant. A warehouse, for example, would not qualify.
In Rev. Rul. 76-319, the IRS ruled a billiard center did not qualify as replacement property for a bowling alley destroyed by fire.
If you are an owner-investor, similar or related in service or use means that any replacement property must have the same business purpose and relationship of services to you as the property it replaces. You must determine:
- Whether the properties are of similar service to you.
- The nature of the business risks connected with the
- What the properties demand of you in the way of management,
services, and relations to your tenants.
The most common example of similar or related in service or use is rental income real estate replaced with other rental income real estate. If you own the property and rent it to a tenant, the similar or related in service or use test is applied to you – not the tenant. The use of the properties by the tenants can be different – they do not have to be similar.
In S. E. Ponticos, Inc., (CA-6) 338 F. 2nd 477, capital gain realized on the condemnation of an industrial warehouse was not recognized because the proceeds were invested in a residential apartment house. The two properties were similar or related in service or use.
Special Rule for Certain Real Property
A special rule applies to the replacement of real property used in your business or held for investment converted as a result of actual or threatened seizure, requisition or condemnation. The term “real property” as used here means land, and generally anything erected on, growing on, or attached to the land. The special rule does not apply to dealer property.
Under this special rule, conversion of real property into “property of like-kind” to be held for either business use or investment is considered a conversion into property “similar or related in service or use” and qualifies for Section 1033 treatment. This more tolerant like-kind test is the same as not included in Section 1031 exchanges before any proposed changes under the 1989 Tax Act.
Under the special real property rule, like-kind property means real property in almost all cases. It does not matter if your condemned property or your replacement property is improved or unimproved. You should consider the nature and character of each property. The IRS treats the following as like-kind property if held for use in business or for the production of income:
- Leaseholds for a term of 30 years or more. The term includes
the initial term of the lease and all optional renewal
- Perpetual water rights, if they are considered real property
rights under state law.
- Any similar continuing interests in real property.
Corporate Stock as Replacement Property
It is not necessary to make a direct purchase of the qualified property. You can qualify by buying stock in a corporation owning qualified replacement property. However, you must buy a controlling interest. The term control means ownership of 80% or more of the total combined voting power of all classes of stock entitled to vote and 80% or more of the total number of shares of all other classes of stock of the corporation.
It’s OK to form a new corporation to acquire the replacement property. However, the qualified replacement property must be owned by the corporation at the time you get control of the corporation.
Improving Property Already Owned
The IRS has sent out mixed signals regarding the replacement of unimproved land with improved property meeting the like-kind test. But they have accepted the reinvestment of net awards into property already owned as long as the like-kind test is met. They have agreed a qualifying replacement was made where the taxpayer reinvested proceeds from condemnation of a manufacturing plant’s land and facilities were used to rearrange the plant facilities on the remaining land and to build a garage on land already owned.
One important tax case permitted the taxpayer to reinvest the proceeds from condemned property in improvements to property already owned. [Davis v. United States, 411 F. Supp. 964 (aff'd, 589 F.2d] 446.
Davis’s agricultural land was condemned. He reinvested the net award proceeds with physical improvements including a water system on industrial land already owned. The Court said the replacement of unimproved property with improved property satisfied the like-kind test. And it agreed the reinvestment in improvements on property already owned satisfied the replacement property qualification.