The Involuntary Exchange
Not all exchanges are voluntary. If your insured home or investment real estate was destroyed by a fire, earthquake, hurricane or other natural disasters beyond your control, you likely will receive insurance proceeds in amounts that are greater than your adjusted tax basis. In this situation, a taxable capital gain exists – even if your property was decimated through an “act of God.”
In these cases, known as “involuntary conversions,” IRC Section 1033 can help you defer the tax on that gain if you are able to acquire or build a replacement property of equal or greater value to the one that was lost.
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.