With the recent Internal Revenue Service-designated Disaster Situations, including IA-2020-05, tax relief for Iowa derecho victims, CA-2020-06, tax relief for California wildfire victims and LA-2020-03, tax relief for Hurricane Laura victims, Section 1033 is a great option for real estate owners with lost or destroyed property to get back on their feet financially by deferring the tax consequences of any relief, whether insurance proceeds or government aid, that is received.
Unlike a 1031 exchange that results in the sale of appreciated property to an outside buyer, a 1033 involuntary conversion arises either as a result of casualty, theft, seizure or condemnation of property and a subsequent realized gain as a result of insurance or condemnation proceeds received.
After the loss of property and the insurance or condemnation proceeds have been received, taxpayers must determine whether the replacement property qualifies within the limitations of Section 1033 and qualifies for tax deferral of any calculated gain. There are a variety of types of property that qualify, with the most common being property similar or related in service or use as the property converted. This is a fairly easy threshold to overcome as, more often than not, in the case of an involuntary conversion of real estate, the proceeds received are used either to replace the property lost directly or acquire a similar property to continue the investment. Past court cases have expanded on this definition, adding additional language to qualified property including:
An additional consideration taxpayers must remember to take into account came about with the passing of the Tax Cuts And Jobs Act of 2017. That act eliminated the ability for taxpayers to include personal property for purposes of a like-kind exchange; that definition including both exchanges under Section 1031 as well as involuntary conversions under Section 1033.
For destroyed property, the replacement period begins with the date of destruction. For property lost due to condemnation or seizure, the earlier of the below three dates triggers the start of the replacement period:
The end of the replacement period is considered to be two years following the end of the gain realization year for destroyed property, and three years following the end of the year for condemned or seized property.
One additional difference of note for the replacement period is that property located within a federally declared disaster area automatically receives a four year replacement period in lieu of the baseline two year window.
To make a 1033 election in the year in which the realized gain is received, taxpayers aren’t required to specifically file anything with the return, but rather are considered to have made the election by not including that realized gain in the gross income on that year’s tax return.
From that point on, the taxpayer is required to maintain their tax basis in their replacement property up until the time of sale, at which point the entirety of the deferred gain will be recognized within the overall gain calculation. As an example, if a taxpayer owns destroyed property with a basis of $600,000 and receives insurance proceeds totaling $650,000, the taxpayer must use the entirety of the $650,000 on the replacement property. The taxpayer’s basis in the replacement property would then be $600,000, with a deferred gain of $50,000. To expand on the consequences of not using the entirety of the insurance proceeds, if only $600,000 of the total $650,000 proceeds received were used on replacement property, the excess $50,000 received would be considered recognized and taxable gain in the year received and would not be eligible for deferral. It’s important that taxpayers keep that part of the rules in mind following the receipt of proceeds, as it can result in an unexpected tax bill that could have easily been planned for and avoided.
Although no taxpayer wants to be in a situation where an involuntary conversion would be an option, it has been and remains a valuable resource within the tax code for real estate owners to get through some of the toughest times imaginable by avoiding the significant tax burden of conversion or sale of real estate. It’s important that taxpayers reach out to their trusted tax advisor to ensure they don’t miss out on gain deferral opportunities and also follow the process correctly to ensure qualified gain deferral.