Condemned Property and Casualty Losses: Your Guide to 1033 Tax Deferral

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.

1033 Exchange Basics

A couple basic rules of a 1031 exchange are that the taxpayer cannot hold or benefit from the proceeds during the exchange period and must 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 a qualified 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. In some cases, you may be able to get even more time by applying to the IRS for an extension.

1031 vs. 1033 Exchanges: Replacement Property

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.

Proceeds received pursuant to §1033 can be used to make improvements on land the taxpayer already owns, as long as his or her 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, while retail stores replaced by a warehouse does qualify.

Deferring Tax with a 1033 Exchange

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 Company is always available to answer your questions and to help you set up a tax deferred exchange, based on Internal Revenue Code Section 1031.