1033 Exchanges – Effective Tax Planning

Most real estate companies are familiar with the Section 1031 like-kind exchange. However, there is another type of real estate exchange, Section 1033 exchange, that can be used by property owners in certain situations. A 1033 exchange is available to those who have had their property condemned under eminent domain or because of natural disaster (fire, floods, hurricanes or tornadoes). When this happens, a taxpayer can leverage the exchange to receive similar tax deferral benefits as offered under a 1031 exchange. While no one wants to be in this situation, the good news is that the rules governing a 1033 exchange are far less strict than for a 1031 exchange. To help you understand 1033 exchanges and their benefits; JLK Rosenberger has provided a summary below of key points.

Key Details of a 1033 Exchange

  • Definition of Condemnation – Many property owners are surprised to learn that just the threat of condemnation is a qualifying event under which a 1033 exchange may be implemented. The IRS requires that the taxpayer have reasonable grounds to believe that if the property is not sold it will be condemned. If the property is sold to someone else other than the condemning authority the transaction is also eligible for the exchange. There are many options and opportunities to be considered by the property owner.
  • Qualified Intermediary Requirement – Under a 1031 exchange the selling property owner must hire a Qualified Intermediary to hold funds between the time the initial property is sold and the replacement property is purchased. However, under a 1033 exchange no such requirement exists. Property owners can hold the funds from the condemnation of property and use them for the acquisition of the replacement property. Since the taxpayer takes possession of the funds they can invest that money in short term investments which is simply not an option under a 1031 exchange. It’s important to note that if all proceeds from the involuntary conversion are not used then they are eligible for taxation.
  • Qualified Replacement Property – The rules depend on the type of property which is being replaced. For example, if the property is used for business or investment purposes, then under IRS regulations it must be replaced with a like-kind property (like regulations governing 1031 exchanges) having a similar use or economic purpose. Other types of property are subject to different rules.
  • Identification Requirement – Under a 1033 exchange, there is no time within which a replacement property needs to be identified. This means that a property owner is not required to follow the strict 1031 rules of 45 days for identifying a replacement property. It’s clear that IRS is more lenient because involuntary conversions are often unexpected and more time is needed for planning,
  • Replacement Timeframe – The replacement period for 1033 exchanges is much longer than 1031 exchanges. A taxpayer has 2 years in which to acquire a replacement if the property was destroyed due to natural disaster and 3 years if it was condemned by government agencies. It’s important to note since there are often delays in payment once a property has been condemned by the government or by an insurance company, the replacement period begins once the taxpayer receives payment. So there is ample opportunity for the impacted taxpayer to search and find an ideal replacement property.

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No one wants to go through the experience of having property involved in an involuntary conversion, but when it happens it’s important to be aware of the tax planning opportunities. If you are interested in learning more about 1033 exchanges, or have questions about real estate tax planning, JLK Rosenberger can help. For additional information call us at 949-860-9902, or click here to contact us. We look forward to speaking with you soon.