KNOW MORE ABOUT 1033 EXCHANGES

Part of the Internal Revenue Code since 1921, Section 1033 provides guidance for the deferral of all tax liability incurred when, as the result of an involuntary conversion, compensation received produces a capital gain.  Known as a “1033 Exchange,”  property owners can avoid current taxation by reinvesting their conversion proceeds into qualified replacement property within specified time periods.

 

The team of advisors at Jamieson Capital offers exceptional knowledge and years of experience in resolving even the most complex of exchange scenarios.  Skilled at utilizing this powerful tax code (as well as 1031), Jamieson can structure exchange solutions that will defer, possibly eliminate, the significant tax burden levied upon conversion proceeds, allowing property owners to keep more of their settlement dollars, tax-free.

1031 vs 1033: THE BASICS OF TAX DEFERRED EXCHANGES

Both Section 1031 and Section 1033 of the Internal Revenue Code provide for the nonrecognition of gain when property is exchanged for qualifying replacement property. While similar in purpose, there are distinct rules separating the two which must be followed closely in order to complete a valid, fully tax-deferred exchange.

 

 

 1031 Exchange

1033 Exchange

USAGE

 

Exchange of property held for productive use in a trade or business or for investment.

 

Exchange of property compulsorily or involuntarily converted as a result of eminent domain, destruction, or theft.

"Equal and Up Rule” Replacing Equity

 

Equity in the replacement property must be equal to or greater than the net equity of the relinquished property.

Equity cannot be replaced by additional debt.

 

The cost of the replacement property must be equal to or greater than the net proceeds received.

Equity can be replaced with additional debt.

“Equal and Up Rule” Replacing Debt

 

The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the relinquished property.

Debt can be replaced with additional equity (cash).

 

The value of debt on the replacement property must be equal to or greater than the value of debt relieved on the property converted.

Debt can be replaced with additional equity (cash).

Replacement Property Standard
 Like-Kind  Similar or relevant in use
Constructive Receipt/
Qualified Intermediary
Within 180 days of disposition, escrow must close on one or more the properties identified as potential replacements.

 

Within 2 years from the end of the first tax year in which gain is realized, escrow must close on one or more qualified replacement properties.

Special rules extend this period to 3 or 4 years.

Proper Vesting

 

The same individual or entity holding title to the relinquished property must purchase replacement property.

 

The same individual or entity holding title to the property converted must purchase replacement property.

Misc.

 

Exchange funds cannot be used to improve the land already owned.

Replacement property can be purchased from a “related” party, subject to certain rules.

 

Conversion proceeds can be used to improve land already owned.

In general, replacement property cannot be purchased from a “related” party.

1033 REPLACEMENT PERIODS

Section 1033 of the Internal Revenue Code of 1954 provides for the nonrecognition of gain  when property is compulsorily or involuntarily converted. Section 1033(a) requires that such conversions occur "as a result of destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." If an involuntary conversion results in a gain, the gain need not be recognized if the proceeds are invested in similar property of equal or greater value within a specified period.

Important in determining a property owner’s replacement period are several criteria, including the type of property and its use at the time of conversion, as well as the kind of property to be acquired. In addition, the manner of conversion (e.g., eminent domain vs. destruction) will dictate the time allowed for replacement.

 

Regarding involuntary conversions by eminent domain, the start of the replacement period is triggered by the earlier of three dates:

 

  1. Date the property was condemned or seized
  2. Date the property was first subjected to threat or imminence of condemnation or seizure
  3. Date the property was sold or exchanged under threat or imminence of condemnation or seizure.

The replacement period for conversions arising from theft or destruction (usually compensable through insurance payouts) begins on the date the incident occurred. Destruction of property, for purposes of §1033, is analogous to casualty under §165 as an involuntary conversion of property arising from fire, storm, shipwreck, or other casualty.

 

Pursuant to 1033(a)(2)(B), the replacement period ends two years after the close of the first taxable year in which any part of the gain upon the conversion is realized. For example, compensation received any time in 2017 must be invested into similar property by December 31 of 2019 to qualify for tax deferral. Although difficult to obtain, the replacement period may be extended with permission from the IRS.

 

Special rules apply to investment real estate converted by seizure, requisition or condemnation (or threat or imminence), but not by theft or destruction. 1033(g)(4) expands to three years the replacement period for property held for productive use in trade or business, or for investment.

 

The replacement period for personal residences destroyed by a Federally declared disaster is extended to 4 years.

QUALIFIED REPLACEMENT PROPERTY: SIMILAR OR LIKE-KIND?

Section 1033 of the Internal Revenue Code of 1954 provides for the nonrecognition of gain when the property is compulsorily or involuntarily converted. Section 1033(a) requires that such conversions occur "as a result of destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." If an involuntary conversion results in a gain, the gain need not be recognized if the proceeds are invested in similar property within a specified period.

 

Replacement property qualifies under this section if it is "similar or related in service or use to the property so converted." The IRS is quite restrictive in its interpretation of the similar use standard:

  • Reinvestment must be made in "substantially similar" property;
  • Reinvestment must be a substantial continuation of the prior commitment of capital and not a departure from it;
  • Character of the investment should not be changed (although replacement property need not duplicate the converted property);
  • Transaction should allow a taxpayer to return as closely as possible to his original position 1033(g)(1) provides a more lenient test for condemned real property “held for productive use in trade or business or for investment,” considering property of a like-kind to be similar or related in service or use. Like-kind property has a broader definition than does similar property. §1031(a)-1(b) provides that properties are of like-kind or like class if they are of the same nature or character, even if they differ in grade or quality. The most common example is rental income real estate replaced with other rental income real estate. Use by the tenants is not required to be similar, and can differ.

Property that does not qualify as like-kind may still be eligible under the service or use test, which the IRS has divided into two tests. Revenue Ruling 64-237 presents the distinction between two classes of owners: the owner-user and the owner-investor.

 

A functional test applies to owner-users. Property is not considered similar or related in service or use unless the physical characteristics and end uses of the converted and replacement properties are closely similar. For example, owner-users of a manufacturing plant must reinvest in replacement property having the same end use - another manufacturing plant. A warehouse would not qualify.

 

Determination of similar service to the owner-investor is focused on the similarity in the relationship that both properties have to the owner. In applying this test, the nature of business risks associated with the property, the management and service demands of the owner, and relationship to the tenants must be considered. Owner-investors can benefit from eased replacement standards, as the replacement of investment property with property of like-kind is treated as similar.

Examples of Similar in Use Property

  • Improved rental property replacing unimproved land subject to construction contract
  • One building replacing two buildings used for the same purposes
  • Replacement of destroyed facilities on leased land in one location by construction of similar facilities on leased land in another location
  • Stock in public utility corporations replacing stock in condemned private utility

Examples of Property Not Similar in Use

  • Improved real estate replacing unimproved real estate
  • Reduction in leasehold or mortgage indebtedness replacing real property
  • Interest in real estate investment trust replacing leased commercial building.
  • Shopping center replacing underdeveloped land
  • Partnership interests replacing partnership assets

Examples of Like-Kind Replacement Property

Most real estate is considered like-kind to other real estate. Improved real estate is like-kind to unimproved real estate as both are the same kind of property (real property).

  • Investment realty replacing condemned business realty, or vice-versa
  • Duplex for a retail property
  • Single family rental for a multi-family apartment
  • Commercial property replacing condemned agricultural land
  • Conservation easement replacing timberland, farm land or ranch land, provided easement qualifies as an interest in real property under law

Examples of Property That is Not Like-Kind

  • Constructed motel on land previously owned replacing condemned mobile home park
  • Personally-used residence replacing leased residential property
  • Interest-bearing bonds and a savings account replacing income producing real estate
  • Fee simple interest replacing 15-year leasehold
  • Partnership interests in oil and gas properties replacing condemned oil and gas wells
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