Unfortunately, 2017 has been a year of major disasters due to floods, hurricanes and fires. As we turn our attention from preventing loss of life to the process of restoring property, some of our clients have been asking whether it makes sense to do a 1033 exchange rather than a 1031 exchange. This article examines some of the differences between the two tax breaks. Although this is a quick summary, it’s crucial to discuss your specific situation with your tax advisor.
A section 1033 exchange applies when you lose property through a casualty, theft or condemnation, and realize gain from the insurance or condemnation proceeds. If your tax advisor says that you will realize gain from the insurance or condemnation proceeds, you may be able to defer that gain using 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.
A couple basic rules of a 1031 exchange are that the taxpayer cannot hold or benefit from the proceeds during the exchange period, and has to identify replacement property within 45 days and acquire replacement property within 180 days after the closing of the relinquished property. If you are deferring gain in a 1033 exchange, you can hold the proceeds until you acquire the replacement property, and you don’t need to use an intermediary.
The 45 day identification period does not apply in a 1033 exchange, although you do identify what you will acquire on your tax return. The time frame for acquiring replacement property is generally two years, although in some cases it can be even longer. For example, if your property is being condemned, you have three years to finish the exchange. Moreover, if you have lost your primary residence in a federally declared disaster, there is an additional rule that gives people up to four years to complete their 1033 exchange. (See IRC Section 1033(h).) In some cases you may be able to get even more time by applying to the IRS for an extension.
Another difference between a 1031 and a 1033 exchange is the standard that is used to limit what you can buy as replacement property. In general, the replacement property must be “similar or related in service or use” to the property that was lost in the casualty or condemnation. In most cases, this standard is more restrictive than the like kind standard under IRC 1031.
There is an alternative standard for replacement property, but only if the property is lost due to a condemnation and was held for productive use in a trade or business. In this case, the replacement property qualifies if it is “like kind” to the converted property. 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.
A 1033 exchange is a useful tool to defer tax when you lose property because of a casualty or condemnation yet have gain from the insurance or condemnation proceeds. These are some of the basic rules, but if you are contemplating a 1033 exchange, you should investigate the details further with your tax advisor. First American Exchange is always available to answer your questions and to help you set up a tax deferred exchange, based on Internal Revenue Code Section 1031.
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