What is a 1033 exchange?

When a 1033 applies

A 1033 exchange applies when property is involuntarily converted through condemnation or eminent domain, a threat of condemnation, destruction, fire, flood or storm, theft, seizure, a federally declared disaster, or other circumstances beyond your control.

Section 1033 of the Internal Revenue Code addresses these situations, known as involuntary conversions. When the proceeds exceed your adjusted basis, the difference can create a taxable gain, resulting in a tax bill from property you never chose to sell.

For example, a building bought for $600,000 and depreciated to $400,000 that is condemned for $1,500,000 has a realized gain of $1,100,000.

Section 1033 lets you defer that gain if you replace the property with qualifying replacement property within the time allowed. The type of event matters because the replacement-property requirements and deadlines vary based on what caused the involuntary conversion.

How long you have to replace

The replacement period is longer than a 1031 exchange, and it is measured from the end of a tax year, not from a closing date.

• Two years from the close of the first tax year in which any part of the gain is realized. This covers casualty, theft and destruction, and the condemnation of anything other than business or investment real estate, such as your home.
• Three years where real property held for business or investment is condemned, requisitioned, or sold under threat of condemnation.

Because the clock starts at a year end rather than at the event, a condemnation early in the year can leave close to four calendar years to reinvest. The window opens at the first threat of condemnation, so replacement property bought after the threat can count.

What counts as replacement property

The general test is that replacement property must be similar or related in service or use to what was lost. That is narrower than the like-kind standard of a 1031 exchange — it looks at how the property is actually used, not simply whether both are real estate.

There is an important exception. Under Section 1033(g), where real property held for business or investment is condemned or sold under threat of condemnation, the broader like-kind standard applies instead, and the range of qualifying property is considerably wider.

Which test applies to you changes what you are allowed to buy. Establish that with your tax advisor before you start looking.

Two conditions to watch

Make the election. Deferral is elective, not automatic. Your tax advisor makes the election on your return, with a statement describing the conversion and the replacement. If it was missed, ask promptly whether an amended return can still make it.

How a 1033 differs from a 1031

Keeping cash in a 1033 exchange

In a 1031 exchange, the rule of thumb is to trade “equal or up”: buy property worth at least what you sold and reinvest all of your equity. Any cash you keep is taxable.

A 1033 exchange asks only for the first half. Your replacement property must cost at least your net award, and that cost counts the debt that comes with the property, not just your cash. Debt can take the place of cash, so part of your award can stay with you while all of your gain is still deferred.

Higher leverage may increase potential gains or losses. The 1033 Cash Out Calculator shows how much cash you can keep at each DST loan-to-value, and your tax advisor has the final word.

Where a DST can fit

A Delaware Statutory Trust (DST) interest may qualify as replacement property when business or investment real estate is condemned or sold under threat of condemnation. In that case the broader like-kind rule applies, and a properly structured DST interest is treated as direct ownership of real estate.

Which rule applies to you depends on how the property was held and whether it was condemned, so confirm it with your tax advisor. If you’re considering a DST, we can discuss how one may work with your exchange timeline.