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1033 Exchanges

Section 1033 of the Internal Revenue Code  governs the tax consequences when a property is compulsorily or involuntarily converted in whole or in part into cash or other property. This is commonly referred to as an “involuntary conversion” since the loss of property is beyond the control of the taxpayer and realize gain because the insurance or condemnation proceeds exceed the owner’s tax basis in the property. Section 1033 does not require a QI. In a Section 1033 Exchange, the taxpayer can receive the sales proceeds and hold them until the replacement property is purchased. If not all the proceeds are used towards acquiring the replacement property, the taxpayer is taxed on the difference.

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Bravest Wealth Management can help structure exchange solutions that will defer, possibly eliminate, the significant tax burden levied upon conversion proceeds, may allow property owners to keep more of their settlement dollars, tax-free. If you believe you could benefit from working with a financial professional, let’s review your goals to see if you’re a good match for our practice.

1031 vs 1033: The Basics of Tax Deferred Exchanges

1031 vs 1033: The Basics of Tax Deferred Exchanges

Both Section 1031 and Section 1033 of the Internal Revenue Code provide for the nonrecognition of gain when property is exchanged for qualifying replacement property. While similar in purpose, there are distinct rules separating the two which must be followed closely in order to complete a valid, fully tax-deferred exchange.

1031 Exchange

Property Replacement Standard:

Proper Vesting:
The same individual or entity holding title to the relinquished property must purchase replacement property.

Exchange funds cannot be used to improve land already owned.

Replacement property can be purchased from a “related” party, subject to certain rules.

1033 Exchange

Property Replacement Standard:
Similar or Related in Service or Use or Like-Kind

Proper Vesting:
The same individual or entity holding title to the relinquished property must purchase replacement property.

Conversion proceeds can be used to improve land already owned.

In general, replacement property cannot be purchased from a “related” party. 

1033 Replacement Periods

Important in determining a property owner’s replacement period are several criteria, including the type of property and its use at the time of conversion, as well as the kind of property to be acquired. In addition, the manner of conversion (e.g., eminent domain vs. destruction) will dictate the time allowed for replacement.

Regarding involuntary conversions by eminent domain, the start of the replacement period is triggered by the earlier of three dates:

  1. Date the property was condemned or seized
  2. Date the property was first subjected to threat or imminence of condemnation or seizure
  3. Date the property was sold or exchanged under threat or imminence of condemnation or seizure

The replacement period for conversions arising from theft or destruction (usually compensable through insurance payouts) begins on the date the incident occurred. Destruction of property, for purposes of 1033, is analogous to casualty under 165 as an involuntary conversion of property arising from fire, storm, shipwreck, or other casualty.

Pursuant to 1033(a)(2)(B), the replacement period ends two years after the close of the first taxable year in which any part of the gain upon the conversion is realized. For example, compensation received any time in 2023 must be invested into similar property by December 31 of 2025 to qualify for tax deferral. Although difficult to obtain, the replacement period may be extended with permission from the IRS.

Special rules apply to investment real estate converted by seizure, requisition or condemnation (or threat or imminence), but not by theft or destruction. 1033(g)(4) expands to three years the replacement period for property held for productive use in trade or business, or for investment.

The replacement period for personal residences destroyed by a Federally declared disaster is extended to 4 years.

Qualified Replacement Property: Similar or Like-kind?

Section 1033 of the Internal Revenue Code of 1954 provides for the nonrecognition of gain when the property is compulsorily or involuntarily converted. Section 1033(a) requires that such conversions occur "as a result of destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." If an involuntary conversion results in a gain, the gain need not be recognized if the proceeds are invested in similar property within a specified period.

Replacement property qualifies under this section if it is "similar or related in service or use to the property so converted." The IRS is quite restrictive in its interpretation of the similar use standard:

  • Reinvestment must be made in "substantially similar" property;
  • Reinvestment must be a substantial continuation of the prior commitment of capital and not a departure from it;
  • Character of the investment should not be changed (although replacement property need not duplicate the converted property);
  • Transaction should allow a taxpayer to return as closely as possible to his original position 1033(g)(1) provides a more lenient test for condemned real property “held for productive use in trade or business or for investment,” considering property of a like-kind to be similar or related in service or use. Like-kind property has a broader definition than does similar property. 1031(a)-1(b) provides that properties are of like-kind or like class if they are of the same nature or character, even if they differ in grade or quality. The most common example is rental income real estate replaced with other rental income real estate. Use by the tenants is not required to be similar, and can differ. 

Property that does not qualify as like-kind may still be eligible under the service or use test, which the IRS has divided into two tests. Revenue Ruling 64-237 presents the distinction between two classes of owners: the owner-user and the owner-investor.

A functional test applies to owner-users. Property is not considered similar or related in service or use unless the physical characteristics and end uses of the converted and replacement properties are closely similar. For example, owner-users of a manufacturing plant must reinvest in replacement property having the same end use - another manufacturing plant. A warehouse would not qualify.

Determination of similar service to the owner-investor is focused on the similarity in the relationship that both properties have to the owner. In applying this test, the nature of business risks associated with the property, the management and service demands of the owner, and relationship to the tenants must be considered. Owner-investors can benefit from eased replacement standards, as the replacement of investment property with property of like-kind is treated as similar.

1033 and Tax-Free Conversion Proceeds

One of the most powerful provisions of 1033 is the ability to replace equity in the converted property with new debt on the replacement property, a transaction strictly prohibited by §1031. By increasing the debt, the “equal and up” replacement requirement can be accomplished with less reinvestment of the conversion proceeds. This process also creates an opportunity for a refund if the tax has already been paid.

Ex 1: Gain not reported

In May of 2022, an investor had rental property taken through the process of eminent domain, receiving compensation of $1,000,000 in October 2022. An election for nonrecognition under Section 1033 is made on the 2022 tax return. 1033(a)-2(A) requires the property owner, by December 31, 2022, to purchase qualifying replacement property valued at $1,000,000 or more for full tax deferral.

In February of 2023, the investor purchased beneficial interests in a Delaware Statutory Trust. The trust acquired a 300 unit luxury apartment complex with 47% cash and a mortgage of 53%, a loan-to-value (LTV) of 53%. By investing $470,000 of equity and adding $530,000 of new, non-recourse financing, the property owner has purchased replacement real estate valued at $1,000,000, fulfilling the requirement of 1033(a)-2(A), resulting in full deferral of the gain. The remaining proceeds of $530,000 need not be reinvested in replacement property and is completely tax free to the owner.

Highly leveraged DSTs (75%-80% LTV) have been structured for this purpose, as well as other advanced exchange techniques. In the scenario above, $750,000 to $800,000 would be retained in cash, free of tax by investing $200,000 to $250,000 of the $1,000,000 award.

Ex 2: Gain reported

In May of 2022, an investor had rental property taken through the process of eminent domain, receiving compensation of $1,000,000 in October 2022. Gain was reported and paid in April of 2023.

In 2024 (still within the replacement period), a DST holding title to 16 brand-name stores with a loan-to-value of 78% is purchased as qualified replacement property and designated as such on the 2022 return. By investing $220,000 of equity and adding $780,000 of new, non-recourse financing, the property owner has purchased replacement real estate valued at $1,000,000, fulfilling the requirement of 1033(a)-2(A).

Pursuant to IRC 6511, the property owner can, until April of 2026, file a claim for refund of 2022 taxes paid (three years from the due date of the 2022 return). In the scenario above, the property owner can receive a refund of the tax paid in 2023, and retain the remainder of the proceeds not invested in the replacement property - tax free. 

While replacement property and financing can be secured personally by the owner, DSTs facilitate the process as the debt is already in place without the need for lender approval. Due diligence has already been completed, and closings can take place in a matter of days. In addition, DSTs historically have benefitted from lower, institutional interest rates that may be unavailable to the public markets.

Examples are for hypothetical purposes only and actual properties and results will vary. DST properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last two years, and reasonably expects the same for the current year) and accredited entities only. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation.