Section 1033 of the IRS tax code covers various forms of involuntary conversion of taxpayer property. Conversions occurs when property is destroyed, stolen, condemned or disposed of under threat of condemnation and the taxpayer receives other property or money in payment (e.g., insurance proceeds or a condemnation award).
For 1033 exchanges involving a government taking investors can switch from non cash flowing land or management properties such as apartment building to NNN Properties and Tenant in Common that that can produce predictable cash flow and require little to no management.
A common strategy by 1033 exchange investors is to use highly leverages replacement properties to free up equity that would otherwise not be easily available. These highly leveraged properties are commonly referred to as Zeros because there is no net cash flow while the debt is being paid off. Typical leverage for Zeros range from the high 80% for fee simple properties to the low 90% for leaseholds.
Depending on the type of forced conversion different rules apply. Below is a summary of different involuntary conversions. The text below is for general informational purposes only and is not meant as legal or tax advice. Facts and circumstance can vary and it is important that the taxpayer consult their tax professional.
The election to defer all or part of the gain realized in an involuntary conversion is made by excluding the gain from the gross income on the tax return for the year in which it is realized using Form 4797. Taxpayer must provide details of the involuntary conversion, details on the replacement property purchased or notification that they plan on purchasing a replacement property (length of time to purchase qualified replacement property varies, see below).
Replacement Property can be other property similar or related in service or use to the converted property or an 80% control of a corporation owning the replacement property. An actual purchase must take place. Title must have passed, an enforceable contract of purchase is not sufficient. In situations involving real property used in a trade or business (other than inventory or property held primarily for sale) or as an investment the replacement property does not need to be similar or related in service or use to the converted property but needs to be “like-kind.” The “like-kind” test is more liberal than the “similar use” standard. The “like-kind” standard is not applicable to the acquisition of 80% control of a corporation or the involuntary conversion by fire, storm or other casualty.
Purchase of replacement property must be completed within a period of time that begins on the actual date of the destruction, condemnation or the date on which the threat or imminence of condemnation or requisition begins, whichever is earlier. Generally the replacement period ends two years after the close of the first tax year in which any part of the gain on the conversion is realized. For business or investment real property (other than inventory) the replacement period ends three years, rather than two years after the close of the first tax year in which any part of the gain is realized. This three year period does not apply to property involuntarily converted through destruction (casualty) or theft.
Source of Funds
Funds from any source can be used to purchase the replacement property. The purchase price of replacement property could include mortgages. If Principal Residence is involuntarily converted any gain may be excluded up to $250,000/$500,000 (single/married). If gain is above these thresholds taxpayer may defer recognizing the excess by purchasing a qualified replacement property. The sale of land within a reasonable time following the destruction of a principal residence can quality as part of the involuntary conversion.
The replacement period for principal residence in a declared disaster area is four years. For property located in the Hurricane Katrina disaster area the replacement period is five years if substantially all of the use of the replacement property is in the disaster area.
Property lost in Presidentially Declared Disasters that is compulsorily or involuntarily converted need not be replaced with “similar or related” property. In such circumstances no gain is recognized by the receipt of insurance proceed for unscheduled personal property that was part of the personal residence.
The taxpayer can request an extension of the replacement period. The extension is filed with the IRS district director where the return was filed. There currently is no IRS form to file for extensions.
Comparing Sections 1033 and 1031
A 1033 Exchange does not require the use of a qualified intermediary (you can take the proceeds of the sale as long as you reinvest them according to the rules within 2 to 3 years) while 1031 Exchanges require the funds be placed with a neutral third party. Also the taxpayer can complete the exchange by making improvements in property already owned unlike a 1031 exchange that requires that a new property be purchased.
Taxpayers should carefully review their situation with their tax/legal advisor in both the planning and execution phase of doing a 1033 exchange. As with all major investment decisions it is important that you consult with your tax and/or legal counsel prior to making a final decision. Above information provided for general informational purposes only and is not meant as legal or accounting advice.