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Deferring Gain on Condemned Property - 1033 Exchanges

Sometimes an owner of property can lose that property through a casualty, theft or condemnation, and realize gain because the insurance or condemnation proceeds exceed the owner’s tax basis in the property.  In these cases, even though the owner did not want to dispose of the property, a tax liability is created.  It is possible, however, to defer paying tax on the gain by doing a 1033 exchange. 

Internal Revenue Code Section 1033 provides that gain that is realized from an “involuntary conversion” can be deferred if the owner acquires replacement property that is similar to the property that was lost.  In most respects, the 1033 exchange rules are easier to comply with than those regarding a 1031 exchange, but there are still limitations on which properties qualify as “similar” properties and when those properties must be acquired. 

Involuntary Conversion

IRC Section 1033 allows an owner to defer tax that might otherwise be due if there is an “involuntary conversion.”  An involuntary conversion includes:

  • Property that is destroyed because of a casualty;
  • Property that is lost because of theft; and
  • Property that is transferred because of a condemnation or threat of condemnation

The Basics

Unlike a 1031 exchange, an owner whose property is converted can hold the proceeds until he acquires replacement property, and no intermediary is required.   The owner does not have to be concerned about complying with identification rules, although the replacement property is identified on the owner’s tax return.  The time frame for closing on the replacement property is two years or longer, as discussed below, and the taxpayer can apply for an extension of that time frame in some cases.  In general, the replacement property cannot be acquired from a related party. §1033(i).

Another difference is that proceeds received pursuant to §1033 can be used to make improvements on land the taxpayer already owns, as long as his risks and responsibilities in the replacement property are similar to those in the converted property.  For example, a commercial building built on land that had been leased for farming did not qualify, (Rev.Rul. 76-391), while retail stores replaced by a warehouse does qualify.

Timing

The taxpayer must acquire the replacement property during the “replacement period” which is:

  • DAY 1 OF REPLACEMENT PERIOD: The first day of the replacement period is the earlier of the date of the casualty or condemnation, or the earliest date on which the threat of condemnation occurred.
  • LAST DAY OF REPLACEMENT PERIOD: 2 years (or longer, see below*) after the end of the first tax year when any part of the gain is realized by the taxpayer. The taxpayer should check with his tax advisor to determine when the gain is first realized.

*The taxpayer has 3 years if the converted property is real estate that is held for productive use in a trade or business or for investment, and 4 years if the converted property is the taxpayer’s principal residence and was destroyed as a result of a federally declared disaster.

Replacement Property

In a 1033 exchange, the replacement property must be “similar or related in service or use” to the converted property.  In most cases, this standard is more restrictive than the like kind standard under IRC 1031.  For example, the IRS has held that a billiard center is not similar or related in service or use to a bowling center, and that property used for an owner’s business is not similar to rental property.   

There is an alternative standard for replacement property, but only if (a) the converted property is real property and was held for productive use in a trade or business or for investment, and (b) the conversion was due to a condemnation or threat of condemnation.  In this case, the replacement property qualifies if it is “like kind” to the converted property.  This is an optional standard that the taxpayer can elect to use, and the term “like kind” means the same thing as like kind under IRC Section 1031.  In most, but not all cases, it is easier to comply with the “like kind” standard than the “similar or related in service or use” standard.       

Conclusion

A 1033 exchange is a useful tool to defer tax when a taxpayer loses property because of a casualty or condemnation.  These are some of the basic rules, but owners who are contemplating a 1033 exchange should investigate the details further with their tax advisors.  First American Exchange is always available to answer your questions and, when it is best for you, to help you set up a tax-deferred exchange, based on Internal Revenue Code Section 1031.