The 1033 exchange involves the “involuntary” conversion of property, a situation frequently caused by the government’s power of eminent domain. Eminent domain is defined as “the power of a government to take private property for public use, usually with compensation paid to the owner”. Property owners have limited rights when facing the threat of their property being taken via “eminent domain”.

The treatment of capital gains tax associated with a property that is appropriated by the government via eminent domain is a subject investment property owners need to be aware of. Section 1033 of the IRS Procedural Code addresses how an investor/business owner can defer payment of capital gains taxes when participating in an involuntary conversion of their investment/business property. This process is alternatively called a 1033 Exchange or a 1033 Rollover.

The most common qualifier for a 1033 Exchange is seizure due to eminent domain. Other circumstances that make a property eligible for a 1033 Exchange are:

      • Destruction of the property that is beyond the control of the taxpayer
      • Taking of the property through condemnation

Timing

1033 Exchange rules provide that a tax payer must make a “valid” or “timely” election by not reporting a recognized gain on their tax return for the year that the conversion took place.

Tax payers must replace their 1033 property within the period beginning with the condemnation and ending three years (two years if not condemnation of real property) after the close of the first taxable year in which any part of the gain is realized. Notification of replacement must included in the owner’s tax return for the taxable year or years in which replacement occurs in order to avoid keeping the period for assessment open. The notification must set forth all the details in connection with the investment.

Tax payers should carefully review their situation with their tax accountant.

The Replacement Property

Rules for choosing a replacement property set forth in a 1033 Exchange are very specific. The kind of replacement property is narrower than under a 1031 Exchange.

The types of replacement properties permitted are a function of whether the exchanger was an owner/user or an owner/investor. Make sure to consult with your tax advisor or real estate attorney before selecting your replacement property. Section 1033 allows 2 to 3 years to choose the replacement property. Condemned real estate usually can be replaced by like-kind property, which is less restrictive than the similar-use requirement for other involuntary conversions. The like-kind rule only applies to real estate that is held for productive use in a trade or business or for investment is eligible. The taxpayer must intend and document that the acquired real estate serve as the replacement for the condemned real estate. The replacement requirement can also be satisfied through construction of a replacement property. Funds from any source can be used to purchase the replacement property. The purchase price of replacement property could include mortgages. Tax payers again should carefully review their situation with their tax accountant in both the planning and execution phase of doing a 1033 exchange.

Comparing Sections 1033 and 1031

Under some circumstance it is prudent to elect to participate in a 1031 Exchange (by selling the property before condemnation, for example) rather than doing a 1033 Exchange. Section 1031 Exchanges provide more flexibility than Section 1033 Exchanges when it comes to choosing a replacement property. Section 1031 Exchanges are, however, much more rigid in the time frame for identification/purchase of a replacement property. In a 1031 Exchange you have 45 days to identify and 180 days to complete the sale while a section 1033 allows 2-3 years to close on a replacement.

A 1033 Exchange does not require the use of a qualified intermediary (you can take the proceeds of the sale as long as you reinvest them according to the rules within 2 to 3 years) while 1031 Exchanges require the funds be placed with a neutral third party.

As with all major investment decisions it is important that you consult with your tax and/or legal counsel prior to making a final decision.