The tremendous utility of the 1031 exchange for investors was acknowledged by the creation of the 1033 exchange in 1954. The 1033 exchange is used when a property is converted into cash or a different property compulsorily, such as after a destructive event, or involuntarily, such as through seizure. Usually, this event is a catastrophe for the property owner—either individually, as in the case of a fire at the property, or as part of a larger event, such as a natural disaster that may have affected entire communities. As a result of this conversion, the property owner may experience capital gains from an insurance payment or condemnation proceeding.
Like the 1031 exchange, the 1033 exchange is a tax deferment when a property “similar or related in service or use” is purchased as a replacement for the property converted, and the deferred tax becomes due when the replacement property is sold, unless the property is used in a 1031 exchange.
1033 Exchange Rules Conditions and Benefits
There are a number of circumstances that may cause an investor to lose a property involuntarily. These include loss by:
- Destructive event, such as a fire, earthquake, or hurricane
- Theft (of movable property)
- Eminent domain condemnation or other form of government seizure
In these circumstances, the investor is given the option to reinvest the reimbursement received using a 1033 exchange. This reimbursement might come from an insurance company or the government, depending on the situation. Beyond the structural similarity of the 1031 and 1033 exchange mechanisms, there are a number of differences, however.
Like 1031 exchange rules, the rules for a 1033 exchange are quite complex, but they are more lenient at almost every point. The 1033 exchange can apply to any property that has been subject to involuntary conversion, whether it was held as an investment or used for business (as is the case in a 1031 exchange), or not. Moreover, no qualified intermediary is required in a 1033 exchange. The investor can hold the proceeds of the property conversion and benefit from them (invest them or receive interest from them) before the purchase of the replacement property.
One way in which the 1033 exchange is less permissive than the 1031 exchange is in the nature of the replacement property. The phrase “similar or related in purpose or use” is not defined in the IRC 1033, but it is interpreted to be a much narrower category than “like-kind.” Nearly all commercial real estate is like-kind, with important exceptions, whereas similar purpose restricts replacement options significantly. “Similar or related in purpose or use” applies only in the case of natural disaster, however, as replacement of condemned properties has only to meet like-kind requirements.
1033 Exchange Rules Have Tax Differences and Longer Replacement Periods
Another difference between the two types of exchanges is in their tax treatment. A taxpayer can take a Section 1033 deferral simply by not declaring the gain from the involuntary conversion for the year in which the gain occurred.
There is no identification period for a 1033 exchange, and the acquisition period for the replacement property can stretch to two years, and sometimes more. If the property was condemned, the investor can take up to three years to replace it. A primary residence lost in a federally declared emergency can be replaced within four years. Other special conditions apply to primary residences as well. The investor only needs to designate a replacement property in the appropriate price range and then purchase it within the allotted time to complete the exchange.
Finally, it’s interesting to note that while Pennsylvania is the only state in the country that does not recognize the 1031 exchange, it has followed IRC 1033 since September 12, 2016.
A 1033 exchange can be a great benefit to an investor facing adversity. It is a one-time transaction, after which the investor can take advantage of the 1031 exchange to replace the property obtained and continue to defer the capital gains tax.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 exchange blog posts.
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