When exchanging or investing in properties, it’s important to utilize specific tactics and measures to maximize proceeds. Section 1033 of the Internal Revenue Service (IRS) tax code outlines a regulation regarding the deferral of capital gain taxes resulting from the exchange of property prompted by involuntary conversion. Gain accurate insights into the details of 1033 exchanges to boost the success of your real estate endeavors.
What is a 1033 exchange?
A 1033 exchange is a property investment practice that allows property owners to avoid tax liability on capital gain that occurs as a result of the forced loss of a property. The IRS permits this tax deferral if the owner reinvests the proceeds from their involuntary conversion into like-kind property that is “similar or related in service or use.” Involuntary conversion is defined as loss of property by casualty, destruction, theft, or eminent domain (government seizure). This means that the sale of the property is forced on the property owner and a 1033 exchange omits the owner from tax liability on the revenue from the sale.
What property qualifies for a 1033 exchange?
Replacement property under a 1033 exchange must be like-kind to the property that was involuntarily lost. If the original property is lost due to casualty, destruction or theft, the term “like-kind” is similar to the qualified standard in a 1031 exchange, but with stricter provisions. The use of the new property must be essentially equivalent to that of the lost property. A business owner that lost a retail store cannot replace it with a vacant lot. If the original property is condemned by the government, the more liberal definition of like-kind replacement property is applied from section 1031. In all scenarios, the total value of the replacement property must be equal to or greater than the proceeds gained from the conversion.
Determining the Replacement Period
Several criteria determine the time period the property owner is allotted for replacement. Under circumstances of casualty, destruction or theft, the property owner is given two years from the end of the year in which gain from the conversion is made. Under circumstances of involuntary property loss due to condemnation by eminent domain, the owner is given three years from the end of the year in which the property was seized. Property lost due to a federally declared disaster is given four years for replacement, which begins at the end of the year in which the conversion is made.
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