What is a 1033 Exchange?

In the year 1954, the government introduced section 1033 exchange as a boon for investors. As per the Internal Revenue Code (IRC), any property condemned under eminent domain, acquired through seizure or any other destructive event like a flood, earthquake or a fire accident can be exchanged to receive the tax deferral benefits obtained from 1031 Exchange.

What makes 1033 Exchange distinct from 1031 Exchange?

The involuntary acts of conversion of properties occur due to the following events:

  • Stealing or an act of theft
  • Natural disasters such as earthquakes, hurricanes, fire, storm or any other highly destructive events
  • Condemnation of eminent domain

Since the taxpayers or investors have no control over these environmental occurrences and the massive property loss, they get a reimbursement. The government or the insurance company reimburse the amount of money they have invested in the property, according to losses incurred by the investor due to a particular type of natural disaster. There is no requirement of any Qualified Intermediary (QI) in the 1033 Exchange.

Important Note- For 1033 Exchange, the value of the Replacement Property should be greater than or equal to the net proceeds received from the property. Equity can also be replaced with additional debt.

The rules and regulations of both the 1031 Exchange and the 1033 Exchange are challenging to understand. However, when it comes to the 1033 Exchange, the laws are quite lenient in nature. Given below are a few points which differs 1033 Exchange from 1031 Exchange.

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No need for Qualified Intermediary (QI):

Qualified Intermediary (QI) plays a crucial role in the 1031 Exchange. The moment the property is sold on the Day 0, the investor is required to send all the funds to the Qualified Escrow Account or Qualified Intermediary Trust account managed by the QI. The QI intervenes to ensure the safe and hassle-free transfer and protection of investors fund for a certain period. The period ends with the purchase of a Replacement Property. The QI is an essential part of a 1031 Exchange, but in 1033 Exchange, there is no such law. In 1033 Exchange, the investor is allowed to hold the proceeds of property which they do not own. They can get the profits even if they have doesn’t own the Replacement Property. Besides this, even if they haven’t finalized the Replacement Property yet, they are valid to obtain advantage.

Longer acquisition duration:

The timelines of 1031 Exchange is quite firm in nature. The investor is supposed to complete the transaction of his Relinquished Property to the Replacement Property within the time of Day 45 to Day 180 stated in Section 1031 of the Internal Revenue Code.  In a 1031 Exchange, the government isn’t involved directly. However, in 1033 Exchange, the government and insurance company is involved which leads to delay. The pay-out is often delayed in 1033 Exchange. The more extended period enables the investor to locate a better Replacement Property. Therefore, in 1033 Exchange the time duration is longer than usual. However, as soon as the payment is received by the investor, the period of replacement starts.

What is the timeframe of the 1033 Exchange?

For the 1033 Exchange, there is a stipulated period in which the property can undergo an exchange. Such as:

  • The property which is damaged and used as a primary residence or for any vacation, the time of replacement is two (2) years only. Post first tax year, the conversion gain is realized once the insurance company makes the payment to the investor to replace the converted property into other property of equal value.
  • The replacement period of the condemned properties of government departments is three (3) years.
  • The property which falls in the category of presidentially declared disaster area; their replacement period is increased to four (4) years or more. The year extension makes it an exception. For instance, the relinquished property falls into the category of “Katrina” Hurricane disaster, the replacement period for these properties is five (5) years.

The investor can take advantage of the 1031 Exchange on the property obtained from any illegal means or acquired post-natural disaster. They can continue to defer the Capital Gains Tax since 1031 Exchange is a once in a lifetime transaction.

How to understand “Similar or Related in Service or Use” or “Like-kind” under 1033 Exchange?

As per the section 1033 of the Internal Revenue Code, the properties which are used as a primary residence, vacation home or as a secondary home can only be into ‘Similar or related in service or use.’ It states that reinvestment can and must be done in a ‘substantially similar’ property. For instance, if there is a hurricane and you have lost your primary residential property, then under such circumstances the 1033 Exchange will operate. This feature enables you to buy a similar Replacement Property which can be used as a primary/vacation/secondary residence.

  • A huge vacation home can be replaced for two properties- one vacation home and another residential home
  • If the facilities of your leased land get destroyed during a natural disaster, you can replace it with another familiar location and construct the same facilities to the newly leased land.

Like-Kind Property has much broader and distinct categories. If the property is under an eminent domain threat by governmental departments, that is, involuntary conversion then the investor can replace the property with a Like-Kind Property. For instance, raw land can be obtained against a duplex residential house.

  • Replace a condemned agricultural land against an oil property
  • Replace a duplex house against a retail property

Note– Every taxpayer should keep a copy of a certified mail from condemning authority secure. It works as proof of your proceedings with the administration. In Florida, there is a law to provide written notice to every taxpayer by the condemning authority.