What Qualifies for a 1033 Exchange?

Ben Franklin famously wrote that, “in this world, nothing is certain except death and taxes.” 

While not a certainty, it can be expected that something bad will happen in a part of the country in which you live or hold investment real estate. Tornados, mudslides, floods, wildfires, hurricanes, and other natural disasters have become common seasonal events. 

Investors who have had to relinquish investment properties due to forced conversion from a natural disaster, or through eminent domain, can complete a 1033 exchange to defer all of their realized capital gains. While the rules for completing 1031 exchanges are extremely strict and guided by tight timelines, the rules for 1033 exchanges are a bit more lax.  

Below we’ll cover the basics of the 1033 exchange process and provide insight into what types of properties qualify for 1033 exchanges.  

What is a 1033 Exchange? 

If you have had a home or investment property that has been condemned due to a natural disaster or through eminent domain, you may be able to complete a 1033 exchange. 

Homeowners and investors whose real property assets were condemned through involuntary conversion typically receive compensation from their insurance or a government agency such as FEMA. This payment will trigger a capital gains tax liability when the payment for the forced conversion is greater than the homeowner’s or investor’s cost basis in the asset. 

Similar to a 1031 exchange, completing a 1033 exchange into a like-kind asset allows you to defer taxes on those gains. The rules for 1033 exchanges are different from 1031 exchanges, though.  

• The exchangor must be the same taxpayer that received compensation from an insurance or government agency. 
• The property must have been destroyed and subsequently condemned after a natural disaster, or seized through eminent domain. 

• The replacement property has to be of equal or greater value than the compensation the taxpayer received. The amount of mortgage debt taken on also has to match up to the previous mortgage – it can be greater, but it can’t be less. 
• The replacement asset must be similar in usage. If you are 1033 exchanging an investment property, you must acquire another investment property (more on this below). 
• You have two years to complete the exchange if your property was subject to forced sale through eminent domain. That timeline moves to three years for assets that were condemned following a natural disaster, and four years if the property was in a federally declared disaster area. 
• You don’t need to use a qualified intermediary. 

Assets that Qualify for a 1033 Exchange 

As noted, the replacement asset in a 1033 exchange must be like-kind to the asset that was destroyed, condemned, or seized. 

The replacement property doesn’t necessarily have to be in the same asset class so long as it’s held as an investment. The value of the replacement property must equal or exceed the value of the payout received for the condemned or seized asset – this is commonly called the “equal and up” rule. The amount of debt you take on also has to align, though you can replace a deficiency of debt with out-of-pocket cash, if necessary. 

The primary issue on replacement assets in 1033 exchanges is that they must be substantially similar to the relinquished asset. That’s a broad interpretation, but you’ll likely be fine if you choose a replacement asset that’s held for similar purposes, and your basis in the new asset closely mirrors your financial position in the converted property. You don’t have to replace a condemned property with an asset of the same grade and asset class, but it does have to have the same purpose. 

Replacement examples could include: 

• A triplex for a standalone retail facility 
• A duplex for a single-family rental 
• A retail property for a flex warehouse 

Putting it all Together 

Investors who received compensation after losing income-producing rental properties through natural disaster or had them seized through eminent domain can complete a 1033 exchange to defer any realized capital gain tax liability.  

When searching for a replacement asset, the most important thing to keep in mind is that the replacement property must place you in a similar financial position in the asset. Value and debt should match your original position in the condemned asset. Your replacement asset also should be similar in use, though you are free to change its geographical location, asset class, and quality. 

If you still have questions about which replacement assets qualify for a 1033 exchange, seek the counsel of a qualified professional who has experience in completing this type of exchange.