What is a 1033 exchange?

When a 1033 applies

A 1033 exchange applies when you lose property involuntarily and receive money for it.

Section 1033 of the Internal Revenue Code covers what happens when property is converted into cash or other property against your will. This is called an involuntary conversion, and it usually creates a taxable gain, because the insurance or condemnation proceeds exceed your adjusted basis. A tax bill arrives on something you never chose to sell.

Section 1033 lets you defer that gain if you reinvest the proceeds in qualifying replacement property within the time allowed.

What Section 1033 covers

The section applies to property lost through condemnation or eminent domain, a threat or imminence of condemnation, casualty such as fire or storm damage, theft, and natural disaster.

The gain is measured the same way as any sale: proceeds less adjusted basis. If a building bought for $600,000 and depreciated to $400,000 is condemned for $1,500,000, there is a realized gain of $1,100,000 — on a property never listed for sale.

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.
• 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.

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.

How a 1033 differs from a 1031

The sale. A 1033 follows an involuntary loss. A 1031 follows a sale you chose to make.

The intermediary. A 1033 does not require a qualified intermediary. A 1031 does.

The money. Under Section 1033 you may receive the proceeds yourself and hold them until you reinvest. Under Section 1031, touching the funds disqualifies the exchange.

The clock. Two or three years from a year end, against 45 and 180 days from a closing.

Two conditions to watch

Reinvest the full amount. Gain is deferred only to the extent the proceeds are reinvested. Hold back $200,000 of a $1,500,000 award and that $200,000 is taxable.

Make the election. Deferral is elective, not automatic. It is made by not reporting the gain in the year it is realized, attaching a statement to your return, and reporting the transaction on Form 4797. Miss it and the gain is simply taxable.

Events that may qualify include condemnation or eminent domain, a written threat of condemnation, fire, flood or storm, theft, and federally declared disasters.

Where a DST can fit

Where the condemnation exception applies and like-kind standards are available, a Delaware Statutory Trust interest may be able to serve as replacement property, because a properly structured DST interest is treated as direct ownership of real estate under Revenue Ruling 2004-86.

Whether that works in your case depends on the facts — how the property was held, how it was converted, and which test applies. That is a question for your tax advisor. NexTrend Securities is not an accounting firm and does not provide tax advice.

DST investments are illiquid, involve risk including the possible loss of principal, and are available only to accredited investors. If a DST is one of the options you are considering, we can talk through what is available and how the timing would work.