1033 Exchanges: Important Tax Savings Tool

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Businesses and individuals facing an “involuntary conversion” of property arising from eminent domain, natural disasters, or condemnation often face unique and unexpected circumstances. When a government or other agency forces property to be given up, it can leave the owner feeling uneasy about losing control. Beyond this, tax issues often arise due to income resulting from the transaction. Owners subjected to an involuntary conversion will receive compensation in the form of money, other property, or a condemnation award, creating significant tax liabilities. The good news is this can be avoided through a 1033 exchange, which permits the taxpayer to defer the gain. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.

What is a 1033 Exchange?

A 1033 exchange is a tax-deferred exchange property owners can use to avoid capital gains taxes when selling a property that was lost through an involuntary conversion. These events include destruction through natural disasters, seizure by eminent domain, and condemnation by government agencies. This means that even before the government files a suit for condemnation, for example, property owners may qualify for a 1033 involuntary conversion.

In a 1033 exchange, taxpayers can make a like-kind exchange into a similar property without incurring capital gains taxes.

How Does a 1033 Exchange Work?

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. This could be a natural disaster, such as a fire, flood or earthquake. This could also be condemnation or eminent domain by the government, which could involve filing a suit or simply inquiring about the sale of the property. Government confiscation of the property through seizure or requisition could also be a qualifying event. These could all be considered involuntary conversions.
• Replacement Property: The types of property that are eligible to be used as replacement property include commercial, industrial, retail, and even a principle residence. Remember, the investment rules apply only to a like-kind exchange and not a 1033. In addition, the owner may receive compensation before or after finding a replacement property.. However, they can either use their compensation or an estimated value of their current property to find a like-kind replacement. In the case of condemnation, the value may only apply to a portion of the original property.
• 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 invested so long as the total value of the liquidated property is available for the 1033 exchange once the replacement property is purchased.
• 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 amount of time. While 1031 exchanges have windows of 180 days, the 1033 exchange allows for two years to close on a replacement and typically starts after the receipt of funds. If there is a condemnation, this window begins once the acquisition of the original property is closed.
• Tax Deferral: Once a replacement is purchased, the property owner can defer paying capital gains taxes, if any were to be expected, on the sale of the original property.

Benefits of a 1033 Exchange

The primary benefit of a 1033 exchange is its ability to transfer capital gains taxes. This can be useful for properties subject to involuntary conversion that have appreciated over time and can provide some financial relief during a time when property owners are experiencing other losses.

Using a 1033 exchange also allows taxpayers to reinvest the proceeds from a current to a similar property in a way that could minimize disruptions and build some additional value in a low-risk investment account while a replacement is being arranged. This reinvestment can help property owners rebuild their lives and businesses.

Tax Implications of a 1033 Exchange

Depending on the nature of the conversion and the type of property, taxpayers may be eligible for depreciation recapture and basis carryover.

A basis carryover is when property owners carry over the tax basis of their original property to a new property, and the potential future capital gains on the replacement property can be reduced. The basis of the replacement property is normally calculated by taking the basis of the damaged property and adding in costs incurred in acquiring the replacement property, such as closing costs or improvements.

Suppose the original property was subject to depreciation through something like damages. In that case, taxpayers may be subject to depreciation recapture, where a portion of the gain from the sale could be taxed as ordinary income instead of long-term capital gains. The amount of depreciation recapture would depend on the type of depreciation gained, either straight-line or accumulated, and how long the property was held.

Contact Us

In times of unexpected losses, a 1033 exchange can offer significant relief for property owners. However, the tax implications of a 1033 exchange can vary widely based on individual circumstances. Consulting a tax advisor is essential to understand how it may impact your unique situation. If you have questions about the information outlined above or need assistance with a 1033 exchange, JLK Rosenberger can help. For additional information, call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.