Is Section 1033 Mandatory?

Posted Nov 15, 2023

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The downside of real estate ownership is the specter of property loss. A powerful storm could destroy your private residence, vacation home, or investment real estate. Or you could learn that your parcel of land might be subject to eminent domain seizure. 

While you might receive compensation for your loss, you’re responsible for paying capital gains and depreciation capture taxes on those funds. 

One tool that could help you defer taxes is Section 1033. Though similar to the 1031 exchange (in that the process involves an exchange into other property), the guidelines—and purpose—of a 1033 exchange are different. Furthermore, the non-recognition of gains through the process is mandatory in some cases.

Defining Section 1033

26 U.S. Code § 1033 – “Involuntary Conversions” discusses a method of potentially deferring capital gains or depreciation recapture taxes on property that must be exchanged for another real estate asset. When conducted properly, Section 1033 can allow you to exchange involuntarily converted property into a replacement property of equal or greater value without potentially triggering a taxable event.

Involuntary conversion involves the following:

  • Property destroyed through a destructive event (earthquake, tornado, hurricane, or fire)
  • Property taken by theft (personal property)
  • Property is condemned or is under the threat of condemnation
  • Property that is lost through eminent domain (as long as the loss is compensated and involuntary)

Here’s where it gets tricky. If the real estate involved is your primary or second home, the replacement property must be the same or related in use. In other words, the replacement property needs to be a principal residence or second home.

You also have two years from the end of the tax year to replace that damaged or lost property with another one. However, if your home or secondary home is in a presidentially declared disaster area, you have up to four years to find and acquire a replacement.

Now, suppose the involuntarily converted property involves your business or real estate you hold for investment. In that case, the replacement property also falls under the “similar use” requirement – UNLESS the involuntary conversion results from condemnation or threat of eminent domain. If the involuntary conversion results from destruction, the replacement period is two years. If it results from condemnation, the replacement period is three years.

But . . . is it Mandatory?

The answer here is “it depends.” The factor here is direct conversion versus indirect conversion.

Direct conversion occurs when you convert your damaged, condemned, or government-acquired property into replacement property that is “similar or related in service or use” through the exchange. In this scenario, the non-recognition of gain is mandatory. For instance, if your duplex was destroyed in a hurricane and you use the insurance proceeds for another duplex, this might be considered a direct conversion.

However, if you convert those proceeds into cash or a parcel of raw land, this is considered an indirect conversion. The deferral of any gain realized with an indirect conversion is elective. As such, you’d need to take specific steps to receive non-recognition treatment.

Putting it Together

Section 1033 can be a viable option to assist with tax deferral. However, as this article points out, this code has many moving parts and conditions. Be sure to obtain advice from a qualified professional who is an expert in the process. 

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.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Hypothetical examples shown are for illustrative purposes only.

Costs associated with a 1031 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.

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