Comparing 1031 vs. 1033 Exchanges
No, that reference you skimmed on a tax-deferred exchange website about 1033 exchanges was not a typo. 1033 exchanges do exist, and they do allow real estate owners to replace one property for another while deferring capital gains taxes. 1033 exchanges, however, are not an alternative to 1031 exchanges and are not an exchange strategy you’ll likely consider including in your investment plans.
What is a 1033 exchange?
1033 exchanges benefit those real estate owners who involuntarily convert their property into cash and experience taxable gains. Involuntary conversion of real estate could include:
- The destruction of property due to a natural disaster,
- The loss of property due to an exercise of eminent domain, or
- Property that is transferred as a result of condemnation.
In any of these cases, the property owner could be liable for capital gains taxes if the compensation from either the insurance company or the government agency involved in the seizure or condemnation of the property exceeds the owner’s cost basis in the property.
Under a 1033 exchange, a property owner can defer capital gains taxes by reinvesting their compensation into a qualified replacement property. This process works similarly to a 1031 exchange, but a 1033 exchange has its own unique set of rules.
1033 Exchange Rules
A 1033 exchange has distinct rules that taxpayers must follow closely to ensure a valid, fully tax-deferred exchange:
1. When to Use a 1031 Exchange
The exchange must be made as a result of the destruction or condemnation of a property, or following a seizure through eminent domain.
2. Who Can Exchange the Property
The same individual or entity that holds the title to the converted property must purchase the replacement property. The purchase can’t be made by beneficiaries or partners involved with the property.
3. “Equal and Up” Rule
The new property’s cost must be equal to or greater than the net proceeds received. The replacement property must also have a debt value equal to or greater than the converted property’s debt value. Debt can be replaced with additional equity and vice versa.
4. Replacement Property Requirements
A replacement property under a 1033 exchange must be “similar or related in use” to the converted property, which means that the replacement property must be physically similar to the converted property, and it must be used for a similar purpose. If you lost a rental property, you can’t replace it with a personal residence.
The replacement property also can’t alter the character of your investment. For example, a property subject to a net lease likely can’t be replaced with a property subject to a gross lease.
Generally speaking, the IRS is very strict about these requirements. However, there is a small exception. If the converted property was leased, the replacement property doesn’t have to be used in the same way the tenant used the converted property. Instead, a replacement property’s determination as similar or related in use depends on the lessor’s interest in the property, such as tenant or management requirements.
5. Replacement Period
The replacement period in a 1033 exchange is typically two years for personal and investment properties. The period begins at the end of the first year that any part of the gain is realized, like when you receive your first insurance payout.
If the conversion is a result of condemnation, the replacement period is extended to three years. If the converted property was in a presidentially declared disaster area, the replacement period increases to four years.
6. Reinvestment Proceeds
In a 1033 exchange, any proceeds from the involuntary conversion — such as government or insurance payouts — can be given directly to the investor. The funds do not have to be held by an intermediary at any point. The proceeds can even be placed into short-term investments until escrow closes on the replacement property.
However, high-risk investments could make completing the exchange process difficult. You can’t use any of the investment losses you suffer during the exchange period to offset the cost of the replacement property. Therefore, it’s crucial to keep the proceeds safe during the 1033 exchange period.
1031 vs. 1033 Exchange Regulations
Though in effect, a 1033 exchange and a 1031 exchange may seem to achieve the same goal, the regulations between the two sections of the IRC code differ significantly.
1. A 1033 Does Not Require a Qualified Intermediary
Unlike a 1031 exchange, a 1033 exchange does not require the assistance of a qualified intermediary. Instead, the compensation received for the lost property can remain in the possession of the exchanger until the time a replacement property of a value equal to or greater than the compensating proceeds is purchased.
2. A 1033 Replacement Property Must be Similar
While a 1031 exchange requires the purchase of a replacement property that is considered “like-kind” to the relinquished property, a 1033 exchange requires the purchase of a replacement property that is “similar or related in service or use” to the lost property.
Though these conditions are similar, the 1033 exchange requirements are stricter about the two properties serving the same purpose for the exchanger. For example, if the lost property was the exchanger’s primary residence, the replacement property must also be used by the exchanger as a residence.
3. A 1033 Has a 180-Day Exchange Period
A 1031 exchange has a 180-day exchange period. In contrast, 1033 exchanges have a much longer allowance of time for completion. In most cases, the replacement period is two years.
However, in the case that the lost property was held for productive use in a business, trade, or for investment, (such as a rental property or office building), the replacement period is extended to three years. If you are in a situation where your property was destroyed in a presidentially declared disaster area, the replacement period is extended to four years.
The first day of the 1033 exchange replacement property is determined by the earlier of:
1) the date when the property was destroyed
2) the date when the threat of property condemnation or seizure occurred.
The deadline for the replacement period is two years (three or four years, as discussed above) after the end of the first tax year when any part of the gain was realized by the property owner.
4. A 1033 Does Not Have an Identification Period
One final difference worth mentioning is that 1031 exchangers must abide by the 45-day identification period. 1033 exchangers, on the other hand, do not have to declare candidate properties prior to acquiring a replacement property.
When to Use 1031 vs. 1033 Exchange
If you’re considering selling a property and want to reinvest the money, a 1031 exchange allows you to defer taxes on your capital gains while still potentially getting a return on a replacement property. You have 45 days to identify a new property and 180 days to close on the replacement real estate.
In contrast, the IRC1033 is an option only in specific circumstances or in the aftermath of a natural disaster, accident or other incident on your property. Should you meet the 1033 exchange criteria, you can reinvest gains from insurance or condemnation proceedings.
If you’re unable to use the current property due to an extenuating circumstance, you have two years after the first tax year to find a replacement and reinvest your damage retribution gains.
There are many other differences between these two exchanges. If you have experienced a situation that would qualify you for a 1033 exchange, we recommend working with a tax advisor to understand all of the 1033 exchange benefits and requirements.
Benefits of 1031 vs. 1033 Exchange
Qualifying for a 1031 or 1033 exchange requires that you meet distinctly different criteria, so you need to know your potential eligibility. Depending on your situation, you may be able to meet the criteria for one of the exchange options.
1031 Exchange Benefits
If you do not qualify for a 1033 exchange but can meet the criteria for a 1031 exchange, the 1031 option can offer you several key advantages:
- Tax deferment: The immediate value of a 1031 exchange is that you’re able to defer taxes on your capital gains.
- Restarted depreciation: By investing in a new property, you can essentially restart the depreciation clock, reducing the potential depreciation you would have to recapture.
- Increased diversification: When you’re able to get one or more replacement properties in exchange for your current investment, you can diversify your asset types.
- Increased return potential: When you defer taxes on capital gains, you have greater purchasing power and potentially greater return on your new real estate.
1033 Exchange Benefits
Qualifying for a 1033 exchange is only possible if you’ve faced property damage and loss, forcing you to relinquish your real estate. Because of the unfortunate situation qualifying you for a 1033 exchange, the conditions for tax deferment can help accommodate your needs.
Below are some of the 1033 benefits that largely differ from those of the 1031:
- Long timeline: When you’ve been forced to relinquish a property, you have the benefit of a longer timeline to reinvest anything you recouped from insurance or other gains.
- Pocketed capital: The law does not require that you invest the entire market value of your relinquished property, which means that you can pocket some of your gains tax-free.
- Easier process: You do not need a Qualified Intermediary to handle the exchange, allowing for a more direct process.
- Short-term investments: The law permits you to invest in short-term funds within the two-year window before your investment in “like-kind” real estate.
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