For California Wildfire Victims, a 1033 Exchange Offers Flexibility and Tax Benefits

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Arial view of Pacific Palisades, California before the fire in January 2025No doubt, the victims of Southern California’s wildfires of January 2025 are still catching their breath and trying to envision how they will rebuild their lives after the loss of homes, businesses and communities. Inevitably, some will make the difficult decision not to rebuild and will move on.

For those who decide not to rebuild their homes or businesses, a tax-efficient option exists in the 1033 exchange. For the wildfire victims, perhaps the most attractive part of a 1033 exchange is that there is no immediate deadline for making the election or finalizing the exchange. There’s plenty of time to think it over.

Unlike its better-known cousin, the 1031 “like-kind” exchange, a 1033 exchange can be applied to either residential or business property. Most importantly for the wildfire victims, the required timeline for effecting a 1033 exchange is much longer – in the case of the January 2025 wildfires, it would be nearly five years. So, a 1033 exchange can be considered a long-term solution for property owners who are not ready to make decisions about the final disposition of their burned-out properties.

See our recent article: Federal and California Tax Relief Available to Help Wildfire Victims Rebuild

How is a 1033 Exchange Different?

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 can only be made under certain rather dire circumstances, including:

  • Loss of a property due to a natural disaster such as fire, flood, landslide, earthquake or hurricane, among other events.
  • Condemnation or threat of condemnation of a property by a government agency.
  • Seizure or threat of seizure of a property by 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. Payments larger than the asset’s original cost are typically considered a taxable event. However, if the loss occurs within a Presidentially declared disaster area, and the property is your principal residence, you can elect 1033 treatment, and no gain is recognized for the insurance proceeds received for both the dwelling and its contents, provided you purchase a qualifying asset within the allotted time that completes the exchange.
  • Additionally, owners of a principal residence who experience losses due to natural disasters or by eminent domain seizure may exclude an extra $250,000 – $500,000 of Section 1033 proceeds if the damage was to the owner’s principal residence and purchase a qualifying asset within the required time to complete the exchange.
  • Owners of second homes, rental investment properties, or business/commercial properties who experience losses due to natural disasters or eminent domain seizure and receive compensation for their losses can also elect 1033 treatment on their tax return to defer gain 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:

  • 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, if the original property was lost in a presidentially declared natural disaster – as with the 2025 California wildfires – you have up to four years to replace it. The clock starts on December 31 of the year the loss occurred. So, if your loss occurred early in the year, as with the California wildfires, that gives you almost another year to make the exchange. In the absence of a Presidential disaster declaration, 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.
  • If you experience an involuntary conversion, you may elect 1033 treatment for a principal residence as well as commercial properties, whereas 1031 treatment is available only to owners of commercial properties.
  • If you elect 1033 treatment, you may buy and sell the properties directly without going through a paid intermediary, as is required for 1031 exchanges. No intermediary is required in a 1033 because there is no “boot,” the term used for excess proceeds that a seller may receive and not reinvest in a 1031 exchange. Boot becomes taxable income.
  • With a 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 equal or improve their equity with the replacement property, maintaining the same debt or equity level. Using the 1033 election, you may finance and leverage the proceeds to invest in a more expensive or income-producing property or parlay the proceeds into multiple investments using debt. The ability to use financing, combined with the lack of requirement to maintain equity, allows for quite a bit of flexibility.
  • Rules around reinvestment properties provide more latitude with a 1033 exchange than with a 1031. Under 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.
  • The 1033 exchange offers flexibility by allowing partial reinvestment of equity. If financing exceeds the amount held in the forced conversion, less equity needs to be reinvested. As long as the replacement property’s value equals or surpasses the original, any leftover equity is tax-free and available to be used as the individual sees fit.

Cautionary Notes

If you have excess proceeds after paying for your exchanged property, those amounts should be prorated against the total proceeds required to be reinvested. If you don’t reinvest full proceeds, you may have ordinary or capital gain depending on whether the property was used in business or personal investment. You will need to file amended income tax returns for the year of the loss event or for the year in which 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. It’s best to seek guidance from a trusted tax advisor before making any moves toward a 1033 exchange.

First Steps

The first steps a property owner should take under a 1033 exchange include:

  • Learn how a 1033 exchange works, a process 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.
  • Create a descriptive election statement 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 should be included. This documentation will help formulate an effective election statement.

The January 2025 California wildfires were a reminder that we live in perilous times as property losses rise with the advance of climate change. The 2017 wildfire that destroyed a large section of Santa Rosa, California, and the 2023 fire that destroyed the city of Lahaina, Hawaii, have shown that even properties in cities are no longer safe from violent wind-driven blazes.

While a tax break may not comfort 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 loss of property in the California wildfires, or you own property that is threatened with condemnation or government seizure, JLK Rosenberger can help. For more information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.