1033 Replacement Property

Hi everyone,

I have a question regarding a replacement property for an involuntary conversion. So the details of this is that the client who rents commercial real estate had a parcel that the city was interested in acquiring. The parcel had an office building on it. However the city wanted to acquire only one half of the parcel for eminent domain and then the other half that had the office building on it would be rented through a temporary construction easement (TCE) for about 3 years and possibly extended for 2 years. The acquisition of the land occurred in 2019 and the TCE actually happened in 2017.

I have a couple of questions about this:

1) Since the land portion is the piece being acquired, can my client take the proceeds and invest it in commercial or residential real estate with a building on it? When I read 1.1033(a)-2(b) (https://www.law.cornell.edu/cfr/text/26/1.1033(a)-2), I feel that it should be ok since the relinquished property was used for the rent of commercial real estate. The client wants to use the replacement property in the same way as the relinquished property.

But then I read 1.1033(a)-2(c)(9)(i) and it said that the proceeds of unimproved real estate, taken upon condemnation proceedings, are invested in improved real estate could not be deferred. So it made me question if the replacement property can be a property with a building on it if the funds that were received were for the acquisition of the land.

I am leaning towards it being ok since it's a replacement property for rent. This is what it was for if you consider the whole parcel. But I'd like to hear what other people thought.

2) For the TCE, I wanted to see if there was some way I could include that gain as deferral. I found PLR 201015015 (https://www.irs.gov/pub/irs-wd/1015015.pdf) which had a taxpayer that was able to use funds from a temporary easement for a replacement property. However in that situation, the state agency had the option to take ownership of the temporary easement. The client's situation does not have that.

However, I wanted to make an argument about them being able to because they don't have any way to use the property even though they're getting compensated. Another issue though is that the client received rental income for the TCE back in 2017 for the three years it was being rented. It may be extended to two years later on.

For this one, I was thinking there's nothing I can do to defer the rental income as gain since it was already recognized in 2017. But I was wondering is there a way I can defer it if they decide to extend the TCE another 2 years?

Thanks in advance for any help.

Seems you should be right. The portion taken by the city was part of the improved real estate on which a building was and still is rented out. It only became "unimproved" after the city took it. Now to find authority.

The payment for the 3 to 5 year TCE is probably rental income, but it would be nice to consider it part of the sale of the land. Now to find authority.

There's some language in PLR 9619028 that at first glance is unfavorable.

In considering whether replacement property acquired by an investor is similar in service or use to the converted property, attention will be directed primarily to the similarity in the relationship of the services or uses which the original and replacement properties have to the taxpayer-owner. In applying this test, a determination will be made as to whether the properties are of a similar service to the taxpayer, the nature of the business risks connected with the properties, and what such properties demand of the taxpayer in the way of management, services and relations to his tenants. See , e . g ., Rev. Rul. 80-184, 1980-2 C.B. 232; Rev. Rul. 76-391, 1976-2 C.B. 243; and Rev. Rul. 64-237, 1964-2 C.B. 319.

In this case, the proposed replacement property consists of improvements to another parcel of unimproved real property already owned by the Taxpayer. After the improvement project is complete, the Taxpayer will stand in a different relationship with respect to the services and uses of the original and replacement properties. The original property condemned by State was unimproved realty held for investment purposes. The replacement property, however, would serve a different use to the taxpayer; mainly, the improvements would enhance the value of a separate parcel of land by converting its status from unimproved to improved reality. Consequently, the proposed expenditure does not qualify as a purchase of property that is similar or related in service or use to the converted property within the meaning of §1033(a).

Additionally, §1.1033(a)-2(c)(9)(i) would preclude the proposed expenditure of the condemnation proceeds from qualifying as a purchase of similar use property under §1033(a). Since the end result of the improvement project would be an improved parcel of land, there would be, in substance, an investment of the condemnation proceeds of unimproved real estate into improved real estate. Pursuant to §1.1033(a)-2(c)(9)(i) there would be no investment in property similar in character and devoted to a similar use.

. However, I'd distinguish the facts from yours in that the PLR speaks of a separate unimproved property, while yours is not separate until the city takes it.

More favorable language appears in PLR 9030027

Under the general rule stated in section 1033(a) of the Code and section 1.1033(a)-2(c)(9)(i) of the regulations, improved commercial rental property is not suitable as replacement property to a cattle ranch. If the two properties are dissimilar or unrelated in service or use, gain or loss will be recognized. However, section 1033(g) of the Code provides for nonrecognition if the replacement property is of like kind. Under this more liberal standard, the regulations indicate that it is inconsequential whether any of the land involved is improved or not or that their uses are dissimilar. Rather, it is the nature and the character of the property that is determinative. So long as the replacement property is of like kind, as that term is defined in section 1031 of the Code, it will be treated as property that is similar in service or use to the property so converted. On at least two occasions, the Board of Tax Appeals held that city real estate exchanged for unimproved ranch land qualified for like kind treatment. See E. R. Braley , 14 BTA 1153, Dec. 4743 (1929) (acq.); George E. Hamilton , 30 BTA 160, Dec. 8483 (1934). Rev. Rul. 72-151, 1972-1 C.B. 225, holds that rental real estate (consisting of land and improvements) and farm real estate (also consisting of land and improvements) are properties of like kind.

. I think your facts are very similar.

Take it from here and keep us posted.

Take a look also at DeCleene, 115 TC 457, 11/17/2000, and see which way it sways you.

There's some language in PLR 9619028 that at first glance is unfavorable.

In considering whether replacement property acquired by an investor is similar in service or use to the converted property, attention will be directed primarily to the similarity in the relationship of the services or uses which the original and replacement properties have to the taxpayer-owner. In applying this test, a determination will be made as to whether the properties are of a similar service to the taxpayer, the nature of the business risks connected with the properties, and what such properties demand of the taxpayer in the way of management, services and relations to his tenants. See , e . g ., Rev. Rul. 80-184, 1980-2 C.B. 232; Rev. Rul. 76-391, 1976-2 C.B. 243; and Rev. Rul. 64-237, 1964-2 C.B. 319.

In this case, the proposed replacement property consists of improvements to another parcel of unimproved real property already owned by the Taxpayer. After the improvement project is complete, the Taxpayer will stand in a different relationship with respect to the services and uses of the original and replacement properties. The original property condemned by State was unimproved realty held for investment purposes. The replacement property, however, would serve a different use to the taxpayer; mainly, the improvements would enhance the value of a separate parcel of land by converting its status from unimproved to improved reality. Consequently, the proposed expenditure does not qualify as a purchase of property that is similar or related in service or use to the converted property within the meaning of §1033(a).

Additionally, §1.1033(a)-2(c)(9)(i) would preclude the proposed expenditure of the condemnation proceeds from qualifying as a purchase of similar use property under §1033(a). Since the end result of the improvement project would be an improved parcel of land, there would be, in substance, an investment of the condemnation proceeds of unimproved real estate into improved real estate. Pursuant to §1.1033(a)-2(c)(9)(i) there would be no investment in property similar in character and devoted to a similar use.

. However, I'd distinguish the facts from yours in that the PLR speaks of a separate unimproved property, while yours is not separate until the city takes it.

More favorable language appears in PLR 9030027

Under the general rule stated in section 1033(a) of the Code and section 1.1033(a)-2(c)(9)(i) of the regulations, improved commercial rental property is not suitable as replacement property to a cattle ranch. If the two properties are dissimilar or unrelated in service or use, gain or loss will be recognized. However, section 1033(g) of the Code provides for nonrecognition if the replacement property is of like kind. Under this more liberal standard, the regulations indicate that it is inconsequential whether any of the land involved is improved or not or that their uses are dissimilar. Rather, it is the nature and the character of the property that is determinative. So long as the replacement property is of like kind, as that term is defined in section 1031 of the Code, it will be treated as property that is similar in service or use to the property so converted. On at least two occasions, the Board of Tax Appeals held that city real estate exchanged for unimproved ranch land qualified for like kind treatment. See E. R. Braley , 14 BTA 1153, Dec. 4743 (1929) (acq.); George E. Hamilton , 30 BTA 160, Dec. 8483 (1934). Rev. Rul. 72-151, 1972-1 C.B. 225, holds that rental real estate (consisting of land and improvements) and farm real estate (also consisting of land and improvements) are properties of like kind.

. I think your facts are very similar.

Take it from here and keep us posted.

This is great. Thank you so much for finding these PLRs. I've been researching this for a couple days and couldn't find it. I think that PLR 9030027 is very similar in facts to my client's situation. My client though did ask if he could invest in residential real estate. Now I'm wondering if it matters if the proceeds are invested in residential versus commercial real estate. They're both for the investment of real estate so I am thinking it doesn't matter. I'll be doing some more research on that.