Investors or homeowners who are required to give up their properties due to forced conversion from eminent domain, or if their property is destroyed and condemned following a natural disaster, can complete a 1033 exchange and fully defer any realized capital gains.
In most instances, taxpayers who lose personal property or investment assets to natural disasters or forced conversion will receive compensation from their insurance company or a federal agency such as FEMA. If you receive more for your property than your cost basis, you’ll generate a capital gains tax liability – unless you complete a 1033 exchange.
Below is an overview of like-kind exchanges and how personal property is treated during a 1033 exchange.
There are some major differences between 1033 and 1031 exchanges.
Timelines are much different in 1033 exchanges. In a 1031 exchange, investors have 45 days after selling a relinquished property to formally identify up to three replacement assets, and 180 days to close on a replacement property. These deadlines are inflexible. In a 1033 exchange, though, you typically have between two and three years to complete the exchange depending on what happened to the property. There also isn't a formal identification requirement.
Another key difference is the way funds received from forced conversion or an insurance payout are handled. In a 1031 exchange, the taxpayer can never touch the money – a qualified intermediary must take receipt of all funds throughout the exchange process. In a 1033 exchange, you can take direct possession of any funds received from forced conversion or an insurance payout.
Lastly, you don’t have to invest the entirety of your compensation in a 1033 exchange. If you are able to take on additional debt financing, you can use it to offset the equity required to satisfy exchange reinvestment requirements. In a 1031 exchange, investors can’t use the exchange process to improve their financial position by reducing debt or equity.
Most 1033 exchanges involve the reinvestment of funds received from real estate that was either destroyed in a natural disaster or seized through eminent domain. Like the more well-known 1031 exchange, you are required to replace the lost real estate with a like-kind asset.
However, the term like-kind can be interpreted rather loosely. An investment property must be replaced by another investment property, but it doesn’t have to be the same asset class or grade. You can 1033 exchange a rental home for an income-producing duplex or triplex, or even an income-producing commercial asset, but you can’t replace a vacation home lost in a wildfire with an investment property since they are not like-kind in usage.
Any business or investment property that was lost in a federally declared disaster area is replaceable with any tangible property that is acquired for use in trade or business. Additionally, properties that are lost in such disaster areas aren’t limited to like-kind stipulations. You have four years to find a suitable replacement, and taxpayers will not recognize any gains received from insurance proceeds for personal property that was in their personal residences.
If you lost an investment or personal property due to a natural disaster or eminent domain, you’ll likely receive compensation from insurance or a federal agency. For personal property that was destroyed in an unforeseen natural disaster, you have two years from the time the property was converted to reinvest your proceeds and avoid having to pay taxes on any realized capital gains unless the property was in a federally declared disaster area. In that case you have up to four years to reinvest the funds in a replacement asset and defer any capital gains tax liability.