Most people have a least heard of a 1031 Exchange, but if you ask them about a 1033 Exchange you’ll probably get a puzzled look follow by: “you mean a 1031 Exchange?” While less well known, 1033 Exchanges are another powerful tool included in the Internal Revenue Code (Section 1033 to be exact) that allows for the deferral of tax liabilities resulting from capital gains. The fundamental difference between Sections 1031 and 1033 of the IRC is the cause precipitating the exchange. In the case of a 1031 Exchange, an owner voluntarily sells a piece of real property and then chooses to reinvest the realized capital gains into another “like-kind” property, the operative word being “voluntarily.” A 1033 Exchange, therefore, provides an owner the ability to defer and reinvest any capital gains resulting from an “involuntary conversion,” such as theft, casualty (complete or partial destruction), or eminent domain. Capital gains, in this case, derive from condemnation or insurance proceeds.
1033 Exchanges have rules that are similar to those governing 1031 Exchanges. Like in a 1031 Exchange gains must be reinvested in another real property of equal or greater value within a specified period of time; however, because the conversation is compulsory or involuntary time frames are extended. The minimum time for owners to complete a 1033 Exchange is two years from the end of the tax year in which the gain is realized; however, special rules and/or appeals to the IRS can extend the time to three to four years. The type of conversion impacts the commencement of the replacement period as well. In cases of taking by eminent domain the clock starts on the earlier of: 1) the date the property was condemned/seized, 2) the date the property was subjected to “threat or imminence of condemnation or seizure,” or 3) the date of disposition under “threat or imminence of condemnation or seizure” (IRC Section 1033(a)). With regards to theft or destruction the time period begins on the date the incident occurred. Therefore, if gains are realized at any time in 2018 a 1033 Exchange must be completed by December 31, 2020.
IRC rules take into account the nature and impact of the involuntary conversion and make allowances accordingly. Because the government is placing the burden on the taxpayer in cases where property is taken by eminent domain, the replacement period is extended to three years for property held for productive use in a trade or business or for investment. Another consideration is made for personal residences that are destroyed in a federally declared disaster. In such cases, owners have four years to complete a 1033 Exchange.
Another important distinction is the replacement property standard. For 1031 Exchanges, the property must be “like-kind” as “defined” by the IRS. Defined is in quotations because there is formal definition. Properties are considered of “like-kind” is they are “of the same nature or character, even if they differ in grade or quality.” (IRS.gov). Again, because of the involuntary nature of the conversion, the IRC requires a different standard for 1033 Exchanges, which is both subtle and significant. Properties under a 1033 Exchange must be “similar or related in service or use” with the goal being to return the taxpayer to a substantially similar position prior to the involuntary conversion. The IRS applies a functional test to determine if the standard is met, which distinguishes between owner-users and investors. Replacement properties for owner-users must have similar physical characteristics and end uses while investors benefit from a more lenient standard, which is similar to the “like-kind” standard in 1031 Exchanges. This is because investment properties are income-generating and, therefore, “related in the service or use” refers to the collection of (passive) rental income.
Much like 1031 Exchanges, 1033 Exchanges provide taxpayers with a powerful tool to defer taxes associated with capital gains resulting from insurance or condemnation proceeds due to the theft, destruction, or taking (by eminent domain) of real property. Due to the voluntary versus involuntary nature of the conversions, there are significant differences in the rules governing each, notably the time periods for the exchange and standards for the replacement properties. There are other important distinctions that I will discuss in subsequent articles; including the use of funds, role of qualified intermediaries, replacement of equity with debt, etc. In the meantime, it is always recommended to consult a tax advisor/CPA when contemplating a 1033 Exchange.