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Most real estate owners are familiar with the 1031 “like-kind” exchange, a tax-favored process that allows owners of commercial property to defer the gain on the sale of a property if the proceeds are reinvested in another commercial property. The 1031 process can enable property owners to defer gains for many years as they enhance their real estate portfolios.
Less well-known is the 1033 exchange. The 1033 exchange is very different than the 1031 and – fortunately for property owners who are allowed to elect it, tends to have more flexible rules that work in the taxpayer’s favor in most cases. But as with all tax deferral tools, the 1033 requires a detailed understanding of the rules and careful documentation.
What is a 1033 Exchange?
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, which include:
- Loss of a property due to a natural disaster such as fire, flood, landslide, earthquake, hurricane, and other events
- Condemnation or threat of condemnation of a property by a government agency under eminent domain
In these circumstances, your property may be exchanged for another property, and you may avoid current taxation on the capital gain. Under the Internal Revenue Code, such an exchange is considered an “involuntary conversion” of property.
Owners who experience losses through natural disasters and eminent domain seizures often receive compensation through insurance settlements or government payments. However, payments that are larger than the asset’s original cost are considered a taxable event. In this case, you can elect 1033 treatment on your tax return and start the clock on purchasing another asset that completes the exchange.
There are significant differences between a 1033 exchange and a 1031 exchange, most of which benefit the taxpayer, including:
- If you experience an involuntary conversion, you may elect the 1033 treatment for a principal residence as well as commercial properties, whereas the 1031 treatment is available only to investors in residential and commercial properties.
- If you elect the 1033 treatment, you may buy and sell the properties directly without dealing through a paid intermediary, as is required for multi-party 1031 exchanges. No intermediary is required in 1033 because there is no restriction on allowing the taxpayer to have control over the funds.
- With 1033, the only requirement is that you reinvest the proceeds from the original asset sale or settlement. For 1031 treatment, the taxpayer must reinvest the proceeds and maintain equal or improved equity with the replacement property. If you qualify to use the 1033 election, you may finance and leverage up the proceeds to invest in a more expensive or higher income-producing property or even parlay the proceeds into multiple investments by increasing the debt-to-equity ratio. The ability to use financing and the lack of requirements to maintain equity allows for quite a bit of flexibility.
- A 1031 exchange requires you to act within a tight timeframe, completing the entire exchange process in 180 days or less. But under a 1033 arrangement, you have at least two years to replace the original property and up to three years if the property is used in a trade or business. In the event the original property was lost in a presidentially declared natural disaster, you can have up to four years to replace it, and the clock starts on December 31 of the year in which the loss event occurred. If your loss occurred early in the year, you’ll have almost another year to make a complete exchange.
- Rules around reinvestment properties provide more latitude with a 1033 exchange than with a 1031. Under a 1033, you can use proceeds to buy a partnership interest in a company that owns real estate as long as the real estate is similar in nature to the property that was destroyed, condemned or seized. In other words, if the original property was a manufacturing facility, the partnership investment must hold manufacturing properties.
If you have excess proceeds after paying for your exchanged property, those amounts should be prorated against the total proceeds that were required to be reinvested. That prorated amount becomes a gain that is taxable as ordinary income. You will need to file amended income tax returns for the year of the loss event, or for the year you made the 1033 election.
If, after suffering the loss of your property, you intend to utilize the 1033 process, it’s critical to make your intentions known before reinvesting in any property by making the 1033 election on your tax return. If you don’t make the election before reinvesting, the IRS will deny the 1033 tax treatment for that reinvestment, and your entire gain will be considered taxable income. When making the election, be prepared to identify the facts of your situation, the property that’s involved, the basis of the property, and a computation of the deferred gain. Failure to make the 1033 election in advance of reinvestment is a common mistake.
The first steps a property owner should take under a 1033 exchange would include:
- Learn and understand how a 1033 exchange works, a process that a trusted professional can help with.
- Gather the facts and documentation of your property loss. If it’s a condemnation, all correspondence between you and the municipality or other government agency is required. Copies of any litigation documents are also required. In short, you need to keep track of all documentation that will help you elect 1033 treatment and build your election statement. The election statement should be descriptive and provide a timeline of events. In the case of a casualty by fire, the fire department’s report and all communications with your insurance company and field adjuster report should be reviewed. All of this documentation will help formulate an effective election statement.
One need only read the news headlines to see that property losses are rising and will continue to rise with the advance of climate change. Homes and businesses in Maui were wiped out by wildfire, and increasingly intense hurricanes are hitting the Gulf Coast. These images are becoming all too common. Additionally, rapid growth in urban areas often requires land for new infrastructure – highways, bridges, and public safety facilities. The property for these improvements often comes from eminent domain seizures.
While a tax break may be cold comfort for someone who has lost their home or business, it may provide a little help to come out better on the other side.
We’re Here to Help
If you have suffered a recent loss of property in a disaster, or you own property threatened with condemnation or government seizure, JLK Rosenberger can help. For more information, call us at 949-860-9893 or click here to contact us. We look forward to speaking with you soon.