Preserving Wealth After an Eminent Domain Sale Using a 1033 Exchange

When it comes to deferring capital gains taxes on the sale of real estate, many investors are familiar with the 1031 Exchange. However, fewer are aware of the 1033 Exchange, which is designed specifically for properties that are involuntarily converted—such as through eminent domain, natural disasters, or theft.

While both strategies can offer tax deferral benefits, a 1033 Exchange provides greater flexibility in certain areas, including a longer timeline to reinvest and the ability to take cash from the sale without immediately triggering a taxable event. Understanding the distinctions between the two can be critical when facing an unexpected loss or forced sale of property.

The following case study is a great example of how a 1033 Exchange can be used to defer capital gains taxes and preserve wealth after a property is acquired through eminent domain.

Background:

A family inherited a local furniture store that had been a fixture in their community for decades. The store, passed down through two generations, sat on a well-located parcel of land in a growing city. Although the business had slowed in recent years, the family had no intention of selling—they saw it as part of their legacy.

Challenge:

The situation changed when the city announced plans for a new civic development project. The land the store was located on was designated for public use, and the city initiated an eminent domain proceeding. While the family initially resisted the idea, they ultimately accepted the city’s offer—which they felt was fair and reflective of the property’s market value.

With the sale finalized, the family faced a new challenge: how to manage the significant capital gains from the transaction without losing a large portion to taxes.

Solution:

After consulting with Legacy 1031, the family learned about Section 1033 of the Internal Revenue Code, which allows individuals to defer capital gains taxes when a property is involuntarily converted—such as through eminent domain.

Here’s how the 1033 Exchange helped:

• Extended Timeline: Unlike a traditional 1031 Exchange, which requires replacement property identification within 45 days and purchase within 180 days, the 1033 Exchange gave the family up to three years to reinvest in a suitable replacement.

• Greater Flexibility: As opposed to 1031, no qualified intermediary was needed, and the family was able to take 100% cash at closing with the ability to defer the capital gains tax as long as the proceeds were reinvested within a three-year period.

• Reinvestment Options: With guidance from Legacy 1031, the family reinvested a portion of their proceeds into a Delaware Statutory Trust (DST). This allowed them to maintain exposure to real estate while minimizing the day-to-day responsibilities of active property management.

• Use of Leverage: In a 1031 Exchange, all cash is required to be reinvested to defer taxes. In a 1033 Exchange, debt can be used in place of cash, allowing the investor to complete the 1033 Exchange and keep cash for other purposes.

  
  

Outcome:

In this specific example, not only was the family able to reinvest $1.6 million of the $3 million in sale proceeds they received, but they were also able to keep $1.4 million in cash and eliminate 100% of their capital gains tax liability! Due to the passive nature of the DST investment, the 1033 Exchange allowed them to focus more on their family and less on property management.

Key Takeaways:

• A 1033 Exchange may offer more time and flexibility than a 1031 Exchange for those impacted by eminent domain.

• Investors can choose to reinvest in different types of property, including passive vehicles like DSTs.

• It’s possible to take some cash from the sale and still eliminate the capital gains tax.

• Professional guidance is critical, as the rules around 1033 Exchanges can be complex.

Disclosures:

This case study is for illustrative purposes only. Individual results will vary. This material does not constitute tax, legal, or investment advice. Always consult with a qualified tax advisor or attorney regarding your specific situation. Investments in real estate, including Delaware Statutory Trusts, carry risk, including potential loss of principal. Past performance is not indicative of future results.