If you’ve been following our blog, you’re probably familiar with the 1031 exchange process. Just to refresh, a 1031 exchange is when an investor sells a property and reinvests the proceeds into a second property to avoid paying taxes on the profits (also referred to as ‘deferring’ taxes). Specifically, the investor will avoid paying capital gains and depreciation recapture taxes.
In this article, we’re going to delve into a similar investment option, which is called the 1033 exchange. To illustrate this exchange type, let’s start with describing a hypothetical scenario:
Let’s say that you own a retail space that was recently hit by a hurricane and has been completely destroyed. As if that isn’t stressful enough, you soon learn that you are responsible for paying taxes on any capital gains and depreciation recapture from the compensation you receive for the destroyed property from your insurance company. So, even though it isn’t your fault that your property was destroyed in a hurricane, you are still responsible for paying taxes. Doesn’t seem fair, right?
The good news is, participating in a 1033 exchange can help you get out of paying capital gains tax. If your property has been subject to ‘involuntary conversion,’ meaning it has been condemned, destroyed in a natural disaster, or taken from you due to eminent domain (which is when the government takes property for public use, i.e., seizing a building to make room for a bridge or highway), you may have the option to do a 1033 exchange.
How does a 1033 Exchange work?
If you receive compensation from your insurance company or the government agency involved in seizing/condemning your property, you may be responsible for paying taxes on capital gains. However, you can defer paying these taxes by exchanging the condemned, destroyed, or seized property for a “like-kind” investment that is similar in use to the original property. For example, if you own a multifamily building that has been condemned, you can exchange it for a second multifamily building. However, you can’t exchange it for retail space because that wouldn’t be considered a “like-kind” property. Additionally, the cost of the replacement property must be equal to or greater than the amount of your original property.
There are some key differences between exchanges allowed in IRC Section 1031 and IRC Section 1033:
No Exchange Accommodator
There is no requirement under Section 1033 that a third party accommodator be engaged to hold and then reinvest the conversion proceeds.
Less Restrictive Timelines
If the damaged or destroyed real estate was being used for personal use (i.e. your primary residence or a vacation property), the replacement period is generally two years after the end of the first tax year when any part of the gain is realized (i.e. you received the insurance payout). However, if the property was in a presidentially declared disaster area, the replacement period is extended to four years.
If the damaged or destroyed real estate was an investment property, the replacement period is generally two years (unless the involuntary conversion is the result of a condemnation or threat of condemnation in which case the replacement period is three years).
Unlike a Section 1031 exchange, the timelines under Section 1033 can be extended for reasonable cause if the taxpayer files the appropriate application for extension.
“Like-Kind” vs “Similar or Related in Service or Use”
Real estate used for personal use, such as your primary residence or vacation/second home, can only be converted into property “similar or related in service or use”. So, for example, if your vacation house is destroyed in a hurricane, then under a Section 1033 exchange, you can only acquire another property that you plan to use for personal enjoyment such as another vacation house. The property type does not have to be identical (i.e. you can buy a vacation condominium to replace a vacation beach house).
Real estate used as investment property is generally subject to the same “similar or related in service or use” standard unless the involuntary conversion is the result of a condemnation or threat of eminent domain. In these condemnation situations, Section 1033 allows the less stringent “like-kind” standard associated with Section 1031 exchanges. For example, if your duplex is lost due to a condemnation, you can exchange into raw land, retail real estate, or a single-family rental house.
Use of Proceeds
Unlike Section 1031, IRC Section 1033 does not require the proceeds from involuntary conversions (i.e. insurance or condemnation payouts) be held by an intermediary and invested directly into the replacement property. Involuntary conversion exchanges only require that the replacement property be of equal or greater value. This means that if you can acquire the replacement property with debt, you may be able to keep some of the conversion proceeds in your pocket and still defer the capital gain taxes.
Losing your real estate due to a natural disaster or a condemnation is never fun, but incurring tax liability would only make things worse. IRC Section 1033 exists to help taxpayers avoid paying taxes due to involuntary conversions. Of course, the tax implications of any exchange can be significant and you should always consult a tax professional.
If you have any questions regarding 1031 exchange guidelines, extensions, or any other exchange related matter please give Realized a call at 877-797-1031.