Lost Your Investment Real Estate to a Natural Disaster? Don't Get Caught in a Tax Trap

The year 2017 has topped all prior years as the costliest on record for natural disasters in the United States. Some estimates put the loss at over $300 billion.

Consider some of the following:

• California: Massive wildfires followed by a drenching rain leading to mudslides
• Houston: Hurricane Harvey
• Florida: Hurricane Irma
• Multibillion-dollar severe weather losses in Idaho (wildfires) and in the Midwest (tornadoes, flooding)

Much of these losses were levied on real estate holdings, whether residential or held for investment.

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If you were unfortunate enough to have lost investment real estate to a disaster, eminent domain or condemnation, you may be faced with yet another loss: income taxes from your settlement proceeds. If you have investment real estate proceeds from insurance or from a forced sale, gain must be calculated based on your depreciated cost basis in the investment.

A Way Out of a Tax Bind: Section 1033

There is a way to defer this taxable event. Section 1033 of the Internal Revenue Code allows for the opportunity to use the proceeds and reinvest them into other investment real estate or reinvest into the rebuilding of the real estate. This rule has similarities to Section 1031 exchanges, but also is much more relaxed in its rules. Section 1031 is a popular option when deciding to sell investment real estate and reinvest the proceeds to defer the income tax. However, the 1033 exchange comes with a couple of distinct advantages:

• With the 1033 exchange, you can receive the proceeds without using a Qualified Intermediary, vs. a 1031 exchange, which requires you to use a Qualified Intermediary.
• With the 1033 exchange, you generally have two or even three years, in some cases, to make the reinvestment. With a 1031 exchange, you only have 45 days to identify replacement property.

Section 1033 is not just for property destroyed from fire, earthquake, hurricane or other disaster. It also applies to property condemned by a governmental exercise of its power of eminent domain. For instance, in the Seattle area Sound Transit is building a rail system costing in the tens of billions, much of this will go to owners of investment property being forced to sell.

But what if you do NOT want to rebuild in the same spot, and you do NOT want to invest all your proceeds into another piece of investment real estate? There is a solution. In a previous article in Kiplinger, I discussed how the Delaware Statutory Trust (DST) could be used to satisfy the requirements of Section 1031 exchanges. The DST also is available for proceeds from condemnation and involuntary conversions.

Avoiding Taxes on a $900,000 Gain

For example, Ben, age 72, owned a small warehouse purchased years ago, with a cost basis of $100,000. The flooding from Hurricane Irma ruined the structure and his customers needed to find other buildings in which to store their goods. Ben is not interested in rebuilding, and even if he did, he isn’t sure he could get his customer base back. If he accepts the $1 million insurance proceeds, he will owe capital gains taxes on the $900,000 gain, and lose all possibility of a future step-up in basis. The step-up on basis potentially allows heirs to permanently eliminate the tax on this $900,000 gain.

Instead, he finds an investment adviser experienced with DSTs. Upon receipt of the insurance proceeds, he spreads the money across various Class A multi-family apartment buildings, and some medical office buildings. Within a month of this reinvestment, he is already receiving his share of the rental income from the DST investments. No more being a landlord, he is receiving monthly cash flow, the opportunity for future appreciation, potential for a future step-up in basis, and best of all, Ben pays no current income tax on the $900,000 gain.

If you were unfortunate enough to have lost investment real estate to natural disaster or governmental condemnation, know that you can at least keep the tax collector at bay with proper planning and execution of a Section 1033 exchange.