Life as a real estate investor can be unpredictable. This is the case when your property is destroyed, condemned, or seized. If insurance or government payouts are higher than what you originally paid for the property, you could be on the hook for capital gains taxes.
Or maybe not.
Successfully employing a Section 1033 exchange strategy could help you defer capital gains on such reimbursements by reinvesting them into other investment real estate.
What Is a 1033 Exchange?
The 26 U.S. Code §1033 is named “Involuntary Conversions” for a reason. Specifically, suppose you’re forced to sell investment or business real estate due to situations outside your control. In that case, you can reinvest the proceeds into a similar investment or business property and defer capital gains proceeds on the sale.
Events outside of your control can include:
- A destructive natural disaster
- Condemnation event or threat
- Government seizure (eminent domain)
- Casualty loss (fire, theft, terrorist attack) if insurance proceeds are received
1033 versus 1031
Section 1031 and Section 1033 are both exchanges. However, the processes differ, as indicated in the chart below:
Reporting to the IRS
The loss or destruction of investment or business property can be compounded if you fail to report it to the IRS correctly. Failure to do so could result in penalties or a loss of tax deferral benefits.
To report a 1033 exchange, use Form 4797–”Sale of Business Property.” The form has sections allowing you to report involuntary property conversions and additional information.
1033 Exchange Examples
The following describes how the 1033 exchange might be used in certain situations.
Eminent Domain
You might own an apartment complex valued at $1 million. However, the government wants the property under that real estate for a proposed road project and offers you $1.2 million in compensation.
To avoid paying capital gains taxes on the $200,000 profit, you have three years to find–and buy–a replacement apartment building or other investment real estate worth at least $1.2 million.
Natural Disaster
Let’s say that the above-mentioned apartment building sits on a major fault line and is destroyed by a massive earthquake. In response, your insurance company pays $1.1 million to replace the asset. Under the rules of a federally declared disaster, you could have up to four years to find a replacement investment property valued at least $1.1 million to potentially defer taxes on the $100,000 capital gains.
Theft or Arson
In this case, a disgruntled ex-tenant you evicted seeks revenge and sets fire to your apartment building. The building is ruled a total loss, the tenant ends up in jail, and your insurance company offers a settlement of $1.3 million. To potentially defer taxes on that $300,000 gain, you have two years to reinvest it into a similar property.
Real Estate Investment Replacement: 1033 Exchanges
A well-planned 1033 exchange could reduce or defer your tax liabilities if your property is destroyed, seized, or condemned. When deciding on this path, work with a knowledgeable tax professional who can help you comply with this exchange’s rules and deadlines.
Also, feel free to contact the experts at Realized 1031 for information about 1033 exchanges and other tax-advantaged strategies. The Realized 1031 team offers decades of experience and can help determine the best solution for your unique financial situation.
To set up a free consultation, visit the website at realized1031.com.
The tax and estate planning information offered is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
