Although many people are aware that real property held for business or investment may be exchanged for other, “like-kind” real property (and certain personal property) while deferring recognition of gain or loss for income tax purposes through a Section 1031 exchange, it is less known that there is another Internal Revenue Code provision that applies to involuntary conversions of real property, such as in a condemnation or after loss of property due to casualty. This is known as the “1033 Exchange,” named for Section 1033 of the Internal Revenue Code.
A taxpayer whose real property has been taken in a condemnation proceeding, or faces a credible or imminent threat of same by a condemning authority, may defer the income tax consequences of the loss of the property by the purchase of a replacement property, or in some cases even by improving other real property that the taxpayer already owns. And unlike a Section 1031 exchange, (i) no third party (qualified intermediary or QI) is necessary to hold the award of the condemnation until the replacement property is purchased and the taxpayer may receive the proceeds and hold them directly until it purchases the replacement property; (ii) the taxpayer does not have to “identify” the replacement property within 45 days of losing the condemned property (relinquished property); and (iii) the time periods to purchase the replacement property are not limited to 180 days from the date of condemnation.
For any condemnation or threat thereof, the taxpayer should secure a letter from the condemning authority stating that it will condemn the property if the taxpayer does not voluntarily sell it, and that the signatory is authorized on behalf of the condemning authority. In Florida, the condemning authority must give written notice to the taxpayer by certified mail of this intention.
The type of replacement property in a Section 1033 exchange depends upon the nature of the condemned property. Generally, the replacement property must be similar in service or use to the condemned property under I.R.C. §1033(a) (similar-use requirement). This is more restrictive than Section 1031's “like-kind” requirement, where all real property is like-kind to all real property. Tax court opinions have consistently explained that the reinvestment must be a reasonably similar continuation of the taxpayer's prior commitment of capital. “While it is not necessary to acquire property which duplicates exactly that which was converted, the fortuitous circumstance of involuntary conversion does not permit a taxpayer to change the character of his investment without tax consequences.” Maloof v. Commissioner, 65 T.C. 263 (1975) (citations omitted). The use may be evaluated using the codes found in the North American Industry Classification System (NAICS), which was created as a collaborative effort by the United States Office of Management and Budget (OMB) and agencies of Canada and Mexico.
Some examples of replacement properties that can be used in Section 1033 exchanges that would not be permitted in Section 1031 exchanges are:
- Building a factory on leased land where the factory replaces one used for the same purposes as the factory on the condemned property.
- Acquiring a factory to replace one that was used by the taxpayer under a long-term lease.
- Using the condemnation award to demolish a building on land already owned by the taxpayer to replace a parking lot that was condemned.
- Using the condemnation award to improve and reconfigure an existing factory to restore it to its previous productivity to replace a condemned factory.
The time period allowed for the taxpayer to acquire the replacement property is much more liberal than in Section 1031 exchanges. The period begins at the earlier of when the taxpayer first discovers the threat or imminence of condemnation proceedings or when the condemnation or other involuntary conversion occurs; that is, when the taxpayer loses title. The period ends either two or three years after the end of the tax year in which the conversion occurs. The time period is three years for real property held for business or investment and two years for all other property. The time period may be extended by filing with the IRS an application for an extension that provides a reasonable basis for the extension. Furthermore, if the taxpayer has lost property in a presidentially declared disaster, Section 1033 gives the taxpayer a two year extension on the replacement period, so the taxpayer has a total of four years in which to replace the lost property.
There are broad restrictions on purchasing replacement property from related parties, and the rules provide details as to which persons would be deemed “related” for this purpose. However, the restriction against purchasing replacement property from a related party would not apply if the related party acquired the replacement property from an unrelated party during the replacement period.
This has been an overview of tax-deferred exchanges under Section 1033 of the Internal Revenue Code. There are subtleties that may need to be analyzed for any specific situation, but taxpayers facing condemnation or having lost property due to casualties should consult with qualified tax advisors to take advantage of the tax deferment if they wish to replace their lost property, in addition to consulting with eminent domain counsel to represent them before the condemning authority. The taxpayers will also need to consult with their tax advisors as to the effect of their intention to use Section 1033 to defer their gain, or to not do elect the deferment, upon their tax returns.