1033 Exchange – FAQs

A 1033 exchange, like a 1031 exchange, involves transitioning from one property to another and receiving a tax benefit. But that’s where the similarities end. A 1033 exchange is only available to taxpayers under certain rather dire circumstances. This includes destruction of property from casualty, theft, seizure, condemnation, or threat of condemnation of a property, among others. In these circumstances, your property may be exchanged for another property, and you may elect to defer the realized gain. Under the Internal Revenue Code, such an exchange is considered an “involuntary conversion” of property.

Owners who experience losses through casualty, theft, and condemnation often receive compensation through insurance settlements or government payments. Such compensation and/or government payments are known as Conversion Proceeds. In the event of Partial Destruction or Condemnation of property and the taxpayer decides to sell the remainder, Sales Proceeds may also be considered Conversion Proceeds if the Sale occurs within the 1033 replacement period. Conversion Proceeds that are larger than the asset’s original cost is considered a taxable event. In this case, you may elect a 1033 exchange to defer the realized gain on your tax return with the intention to fully replace Conversion proceeds in qualifying property within the replacement period required by law.

To qualify for a 1033 exchange, property owners need to meet a few conditions.

• Qualifying Event: A qualifying event must be eligible for the 1033 exchange such as: (1) Destruction of property beyond taxpayer’s control due to casualties such as fire, flood, drought, earthquake, hurricane, shipwreck or other natural disasters; (2) Theft, swindling, false pretenses, and other fraudulent acts; (3) seizure, condemnation, or threat of condemnation of a private property by a government agency for public use.
• Replacement Property: The types of property that are eligible to be used as replacement property include commercial, industrial, retail, and even a principal residence. Remember, the investment rules apply only to a 1031 like-kind exchange and not a 1033. In a 1033 exchange, the scope of replacement property is broader provided the replacement property is similar or related in service or use of the property that was destroyed, taken, or condemned. Gain is deferred to the extent the amount realized exceeds the cost basis.

• Interim: In a 1031 exchange, a qualified intermediary must hold onto the funds before the replacement sale is complete. In a 1033 exchange, this is not required. Funds, instead, can be used in any manner, so long as the replacement property is of equal or greater value than the funds received, and the purchase occurs within the replacement period required by law.

• Reinstatement: The replacement property must serve a similar purpose as the original property, and the property owner must reinvest proceeds from the condemnation or sale into the new property in a certain timeframe. While 1031 exchanges have a 180-day window, the 1033 exchange normally ends two years after the close of the first tax year in which any part of the conversion proceeds were received.

A 1033 exchange defers gain from an involuntary conversion by allowing nonrecognition of gain provided the taxpayer replaces the converted property with a qualifying replacement property within the replacement period required by law.

Replacement Property Key Requirements:

1. Purchase of replacement property was made by the same taxpayer as relinquished property
2. Purchase completed within the replacement period
3. Replacement property must satisfy the applicable similarity standard

Replacement Period:

1. General rule: Two years
2. For condemned businesses or investment real property: Three years
3. Presidentially declared disaster – Primary residence: Four years
4. Presidentially declared disaster – all other properties: Two years with 1-year incremental extensions

Additionally, under Internal Revenue Code Sec. 121, owners of a principal residences may be able to exclude the first $250,000 up to $500,000 from conversion proceeds with no obligation to reinvest such amount into a replacement property.

A 1033 exchange applies to any tangible property that has been involuntarily converted. This applies to  property that has been destroyed, taken, or condemned, and then is replaced with qualifying like property. The rules for this type of exchange focus on both the type of property lost and whether the replacement property is “similar or related in service or use.” For example, a primary residence must be replaced by a primary residence.

Other real property types which include land, commercial buildings, rental property, and farmland held for business or investment purposes taken due to condemnation or eminent domain, the replacement rules can be more flexible and permit taxpayers to reinvest in any real estate that is used in a trade or business.

The rules for personal property are much more restrictive. Examples include business assets such as machinery, equipment, vehicles and other operational assets. In these cases, the replacement property must exactly match the original property’s function and use. The IRS requires that it serve essentially the same function as the destroyed property.

There are also important exclusions. Inventory held primarily for sale does not qualify for 1033 treatment. Property held for personal use can qualify but the replacement requirements are strict and less flexible.