Understanding the rules of a 1033 Exchange aka Involuntary Conversion DSTs provide replacement options for a property sold under eminent domain.
Property owners initiating a 1031 Exchange often end up in that situation by choice after deciding to sell an investment property or business. But what happens when that decision to sell is out of your hands? That is the case when the government steps in to acquire a property by exercising its power of eminent domain.
What is eminent domain?
Eminent domain applies to situations where the federal, state or local government uses its authority to acquire private property for a public use or the greater good. Eminent domain has been around for decades with cases dating as far back as the late 1800s. It is commonly used by government entities to assemble land to build infrastructure, such as roads, interchanges or airport expansion. The government also has been known to step in and utilize its powers of eminent domain to acquire property to pave the way for private sector development that will in some way potentially serve the community or help raise the tax base, such as a new convention center hotel or a hospital. Eminent domain or condemnation also can come into play when a property has been destroyed by a natural disaster, such as flooding, hurricanes or wildfires.
Although eminent domain sounds a bit onerous, property owners are entitled to fair compensation for that property. Once that eminent domain transaction is complete, the question is what to do with that pile of cash? Just as with any property sale where the transaction generates a profit, any income recognized from that eminent domain acquisition is subject to capital gains tax. One way to potentially defer that tax bill is to roll the proceeds from the sale into a tax-deferred like-kind exchange. Whereas the 1031 Exchange is used for tax-deferred reinvestment in most property sales, eminent domain has its own separate category that falls under a 1033 Exchange.