Each year we bear witness to yet another out-of-control wildfire that devastates an entire California community, or another destructive hurricane wracking the Eastern Seaboard or the Gulf of Mexico.
Internal Revenue Code section 1033 provides taxpayers relief for involuntary conversions of personal property due to events such as fire, flood, and other natural disasters, as well as seizure through eminent domain or condemnation.
Below we’ll outline the steps taxpayers need to take to file a 1033 election and the potential benefits that can be gleaned by using this type of property exchange.
What Is a 1033 Election?
Catastrophic natural disasters unfortunately appear to be the new normal for much of America. Taxpayers who experience a complete property loss through natural disasters such as wildfire, landslide, earthquake, or hurricane are often compensated through insurance proceeds for their losses. Likewise for government seizure or condemnation of property.
Taxpayers who receive compensation that’s greater than their asset’s original cost, however, will generate a taxable event on those gains. You can defer those gains by purchasing a like-kind asset using insurance or federal proceeds and completing a 1033 election. A 1033 election is often viewed as a “cousin” to the more well-known 1031 exchange, which allows real estate investors to defer capital gains realized from the sale of an investment property if they use the proceeds to purchase a “like-kind” asset. Unlike a 1031 exchange, though, your property does not have to be used for trade, business, or investment -- you can file a 1033 election with the Internal Revenue Service if your property was involuntarily converted or completely lost through natural disaster.
If your property was condemned or seized through eminent domain, you have three years from the date of condemnation to file a 1033 election. If it was lost from a natural disaster, you have two years to find and acquire a replacement asset.
Filing a 1033 Election with the IRS
Taxpayers who wish to file a 1033 election can indicate with a note that they are filing an election with their annual tax return. Omitting the gain from your tax return in the year the gain was realized also will trigger the election.
Taxpayers must complete the election within the allotted time frame by acquiring a like-kind replacement property. If you fail to close on a replacement asset in the required time you will have to amend your previously filed returns to reflect the gain and pay any associated taxes, interest, and penalties.
One issue that can arise when completing a 1033 election is difficulty finding a like-kind replacement asset since the property must be wholly owned by the taxpayer. Two options exist that can alleviate any ownership burdens associated with acquiring a like-kind asset, though.
Completing a 1033 Election Through a DST or TIC
Taxpayers can purchase shares of a Delaware Statutory Trust or Tenant in Common to satisfy the like-kind requirement and retain the tax benefits gained through the 1033 election. Although these investment vehicles both have fractional ownership structures, the IRS views them as wholly undivided interests, so they both qualify for 1031 exchanges and 1033 elections.
Delaware Statutory Trusts and TICs have different pros and cons that should be carefully vetted with the help of an experienced investment advisor or financial expert.
The Bottom Line
A 1031 exchange is the most common method for real estate investors to defer capital gains by swapping one investment property for another, but the Internal Revenue Service does provide a secondary pathway for real property exchanges that involve involuntary conversions of property or property loss from a natural disaster.
Taxpayers who realize gain after being compensated for property loss can file a 1033 election and defer taxes on those gains by purchasing a like-kind asset within two to three years. The process has some pitfalls, though, so engage the help of a financial adviser with knowledge of the 1033 election process to ensure you remain compliant and avoid an IRS audit.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Consult with your tax advisor regarding your individual circumstances. Costs associated with a real estate transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.