The 1033 Exchange: The Tax Break for When Selling Was Not Your Choice

Most real estate tax planning assumes you chose to sell. Section 1033 is for when you did not.

When property is destroyed, stolen, condemned or sold under threat of condemnation, the insurance payout or government award can produce a taxable gain, sometimes a large one on property held for decades. Section 1033 lets you defer that gain by reinvesting in replacement property. It resembles a 1031 exchange, but the rules are noticeably kinder, which reflects the fact that the owner never wanted to sell in the first place.

What is an involuntary conversion?

Property converted into money or other property without your consent. The main categories are:

• ›Destruction by fire, flood, storm, earthquake or other casualty
• ›Theft
• ›Condemnation, where a government takes property through eminent domain
• ›Sale under threat of condemnation, where you sell to a government body that has made clear it would otherwise take the property

The gain is measured the usual way: the insurance proceeds or award minus your adjusted basis. On long held property with substantial depreciation, that gain can be surprisingly high, even when the owner feels they have suffered a loss.

How is a 1033 exchange more forgiving than a 1031?

In several important ways.

No Qualified Intermediary is required. You can receive the insurance money or condemnation award directly into your own account. In a 1031, touching the money ends the exchange. In a 1033, it does not.

Much longer replacement periods. Instead of 45 and 180 days, you generally have two years after the end of the first tax year in which you realise any gain. For condemned real property held for business or investment, the period is generally three years. Extensions can be requested if you have a good reason.

No 45 day identification. There is no formal identification requirement. You simply need to acquire qualifying replacement property within the period.

Only the proceeds must be reinvested. You need to reinvest an amount at least equal to the insurance or award proceeds to defer the entire gain. There is no separate requirement to replace debt in the way a 1031 requires.

What counts as replacement property?

The general standard is property similar or related in service or use to what was converted. That is narrower than like kind. A destroyed apartment building would generally need to be replaced with rental residential property, not a warehouse.

However, there is an important exception. For condemned real property held for business or investment, the more flexible like kind standard applies, the same one used in 1031 exchanges. That means land taken by a highway project could be replaced with an apartment building, a warehouse or other investment real estate.

Special rules also apply to principal residences damaged in federally declared disasters, including longer replacement periods.

What if you only reinvest part of the proceeds?

Gain is recognised to the extent the proceeds are not reinvested. If you receive 2 million dollars and reinvest 1.7 million in qualifying property, up to 300,000 dollars of gain may be taxable. The unreinvested portion works much like boot in a 1031.

Can a 1033 be combined with a 1031?

In some circumstances, particularly with condemnation, owners may be able to use either provision, and the choice matters. A 1031 requires an intermediary and short deadlines but allows broader like kind property in all cases. A 1033 allows direct receipt of funds and longer timelines. For condemned investment real estate, the like kind standard already applies under 1033, which often makes it the more attractive route.

Where some property is condemned and the owner also sells the remaining parcel voluntarily, the two parts may need to be analysed separately.

How do you elect 1033 treatment?

Deferral is generally elected by reporting the involuntary conversion and the intention to replace on your tax return for the year the gain is realised, then reporting the replacement when it happens. If the replacement is not completed within the deadline, the return must be amended to recognise the gain.

Because the replacement period spans years, good records matter. Keep insurance correspondence, appraisals, condemnation documents, and records of every payment and every purchase.

What are the common mistakes?

• ›Assuming there is no gain because the event felt like a loss. Insurance proceeds on a long held property often exceed adjusted basis.
• ›Missing the replacement deadline. Two or three years feels long until rebuilding delays, permitting and insurance disputes consume it.
• ›Replacing with property that is not similar or related in use, where the stricter standard applies.
• ›Spending the proceeds on non qualifying costs and then being short on the reinvestment amount.

What about Delaware Statutory Trust interests?

For condemned real property held for investment, where the like kind standard applies, investors sometimes consider passive replacement property such as DST interests to reinvest an award they do not want to manage. Whether a particular replacement qualifies under the applicable standard is a question for your adviser, especially for casualty conversions where the stricter similar use test applies.

How does depreciation carry into the replacement?

As with a 1031 exchange, the basis of the replacement property is generally reduced by the deferred gain. That means the deferred gain, including any depreciation that would have been recaptured, continues into the new property and may be taxed when it is eventually sold in a taxable transaction.

It also means that if the replacement costs more than the proceeds, only the additional money creates fresh depreciable basis. Owners rebuilding after a casualty should discuss with their CPA how the new building's depreciation will be calculated before construction starts.

What to do first

If property has been destroyed or a government agency has contacted you about acquiring it, speak to your CPA before accepting settlements or signing agreements. The characterisation of the proceeds, the applicable replacement standard and the exact deadline all affect how much tax you ultimately pay. Start tracking the replacement deadline from the first day.

Nothing here is tax, legal or investment advice. Involuntary conversion rules are technical and fact specific. Confirm your position with your CPA and attorney before acting.