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The following 1033 tax-deferred exchange frequently asked questions (FAQs) have been compiled by our team of tax-deferred exchange experts to provide our clients and their advisors with answers to the most commonly raised questions regarding Section 1033 of the Internal Revenue Code.
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Under Section 1033, an involuntary conversion is defined as a destruction or loss of the property through casualty, theft or condemnation action pursuant to government powers of eminent domain, and the resulting compensation from such destruction or condemnation. [IRC Section 1033(a)].
Even though the sale and/or compensation for the property were essentially forced on the taxpayer, the taxpayer is still liable for any capital gain tax liability on the compensation received. However, if the property is subject to an “involuntary conversion”, the taxpayer has the ability to defer the payment of the depreciation recapture and capital gain taxes on the involuntary conversion under the non-recognition provisions of Section 1033. [IRC Section 1033].
No gain or loss is required to be reported on the tax return for the year of sale or loss. The taxpayer should however speak which their CPA to make sure the details relevant to the conversion and/or loss are reported the year in which they occurred and to notify the CPA that the taxpayer intends to complete a 1033 exchange, as if for whatever reason the exchange can not be completed, then it will be necessary for the CPA to file an amended return reporting the gain. [Regs. Section 1.1033(a)- 2(c)(2)].
If it is clear that the manner in which the taxpayer lost the property was in fact a qualified “involuntary conversion”, then there are two real qualifications the taxpayer must meet to be eligible for non-recognition of gain under Section 1033.
First, Section 1033 only allows non-recognition of gain where the replacement property is purchased within the applicable time guidelines. In cases of casualty or theft, the property must be replaced within a period of two years after the end of the first taxable year in which any part of the gain is realized, in the case of eminent domain, the property must be replaced within three years after the end of the first taxable year in which any part of the gain is realized. [IRC Section 1033].
Second, Section 1033 requires that the property lost to involuntary conversion be replaced with like-kind property. This is similar to the like-kind provision under Section 1031, but no where near as liberal. In order to be deemed like-kind under Section 1033, any proceeds received must be reinvested in property that is “similar or related in service or use” to the property lost, and hence is a much stricter standard than the like-kind standard used under IRC Section 1031 [IRC Section 1033(a)(2)].
For purposes of Section 1033, the restriction means that the end use of the new property must be substantially similar to the end use of the old property. So for example, a taxpayer that lost timberland property used for logging could not replace that property with a parking lot and qualify for non-recognition under Section 1033.
Property that has been condemned enjoys more liberal treatment, and instead of being judged by the “similar or related in use” standard, is determined by expansive definition of like-kind similar to that of Section 1031. This means for the purposes of condemned property, the replacement property will be deemed to be like-kind and the requirements met so long as both the condemned and the replacement property are characterized as real property at law. [IRC Section 1033(g)(1)].
If the property that has been involuntary converted is a leasehold interest, then the lessee's use of the property is not determinative for purposes of the like-kind requirement under Section 1033. Rather, the determination of whether or not the replacement property constitutes like-kind property will be based on the similarity of the lessor’s interest in the property, in such characteristics as the management and tenant requirements. [See Rev. Rul. 71- 41, 1971-1 CB 223].
Yes. In fact, there are special rules that apply if you lost your home in a Presidentially declared natural disaster. In cases where the converted property is in a declared disaster zone, the rules relating to application of Section 121 (see “Frequently Asked Questions under Section 121”) are substantially more liberal.
On property destroyed/lost in a Presidentially declared disaster, Section 1033 provides that any proceeds received for the residence or its contents are treated as received for the conversion of a single item of property, and any replacement property similar or related in service or use to the residence or the contents will qualify as replacement property for the purposes of Section 1033.
Further, if the taxpayer has lost property in a Presidentally declared disaster, as opposed to a ordinary casualty), Section 1033 gives the taxpayer a two year extension on the replacement period, so the taxpayer has a total of four (4) years in which to replace the lost property. [IRC Section 1033(h)].