taxes

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

If your property was flattened by hurricane, fire or even by an eminent domain project, you might have gotten a big settlement check. But that could also mean a hefty tax bill. To avoid that, consider this maneuver.

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.

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.

About the Author

Brian Evans, CPA, PFS

Owner, Madrona Financial Services

Brian Evans is the owner of Madrona Financial Services, Madrona Funds, LLC, and Bauer Evans CPAs and serves as the firms' chief investment officer, lead planner and senior portfolio manager. He was honored to ring the bell on the NYSE. Evans also hosts a weekly radio show on KTTH 770 AM, KRKO 1380 AM and KVI 570 AM, is a nationally published author and has been a regular guest on New Day Northwest, CNBC and Fox television.

Most Popular

The Perfect Storm for Retirees
retirement planning

The Perfect Storm for Retirees

Today’s retirees could face a perfect storm because they are living longer and spending more time in retirement, while at the same time losing access …
April 18, 2021
The Wrong Way to Achieve Wealth
personal finance

The Wrong Way to Achieve Wealth

For some down-to-earth, basic advice on money and life, I have a book to recommend: “Your Total Wealth: The Heart and Soul of Financial Literacy.”
April 17, 2021
Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs
Coronavirus and Your Money

Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs

People have lots of questions about the new $3,000 or $3,600 child tax credit and the advance payments that the IRS will send to most families in 2021…
April 14, 2021

Recommended

Taxes on Unemployment Benefits: A State-by-State Guide
state tax

Taxes on Unemployment Benefits: A State-by-State Guide

Don't be surprised by an unexpected state tax bill on your unemployment benefits. Know where unemployment compensation is taxable and where it isn't.
April 19, 2021
What You Need to Know about College 529 Savings Plans
529 Plans

What You Need to Know about College 529 Savings Plans

Do you know how much you’re able to contribute or what the funds could be used to pay for? How about how contributing affects your taxes? Check out th…
April 14, 2021
2021 Child Tax Credit Calculator
Tax Breaks

2021 Child Tax Credit Calculator

See how much money you'll get in advance under the new child tax credit rules for 2021.
April 14, 2021
Monthly Payments of the 2021 Child Tax Credit Will Begin in July
Coronavirus and Your Money

Monthly Payments of the 2021 Child Tax Credit Will Begin in July

After doubts about whether it was up to the task, the IRS says it's on schedule to start sending monthly child tax credit payments this summer.
April 13, 2021