Section 1031 and 1033 both lets a taxpayer defer capital gains taxes. 1031 and 1033 exchanges offer similar benefits, yet both investments are performed under entirely different situations. 1033 exchanges can only be performed in case of involuntary conversions, like condemnation or eminent domain or loss of property resulting from a natural disaster. Under such a scenario, the investor can use the proceeds obtained as compensation to purchase a new property without the liability of paying capital gains tax.
Over the years, investors have faced difficulties in making the most out of their 1033 exchange investments. A lot of them have also mistaken Section 1033 for Section 1031. It could be possible as just like 1031 exchanges, 1033 exchanges also let investors defer capital gains tax. Therefore, let’s delve deeper into the various aspects of a 1033 exchange.
1033 exchange benefits:
1033 exchanges let real estate investors defer capital gains taxes on buying an income-producing asset after losing an old property to eminent domain or as a result of a natural disaster. In 1031 exchanges, an investor sells the old property first and then uses the proceeds to purchase a new property. However, in 1033 exchanges, the taxpayer is forced to relinquish a personal property by the state or federal government using eminent domain. In return, the investor gets the compensation, which they can use to purchase a like-kind new property. Both the new property and the seized property must be like-kind as per the IRS rules. An investor is also allowed to do a 1033 exchange in case of condemnation or loss of property in a natural disaster. It can be said that in a 1033 exchange, the investor doesn’t sell the old property willingly but is forced to abandon it.
Highlighting the difference between 1033 and 1031 exchanges:
- Unlike a 1031 exchange, you don’t need to involve a Qualified Intermediary when doing a 1033 exchange. You can keep the proceeds or compensation obtained after the seizure or loss of the old property until you buy another ‘like-kind’ property.
- You don’t need to worry about deadlines when doing a 1033 exchange. Plus, you don’t need to identify the new property in advance. You also don’t need to buy a new property within 180 days after the condemnation of the property. You get a period of 2-3 years to purchase the new property. Moreover, you get another 2 years to purchase the new property if the old property was lost in a natural disaster. So, the deadline to buy a new property in such a case will be four years.
- You don’t need to reinvest the entire proceeds in a 1033 exchange, another major difference between both investments. As you may know, when doing a 1031 exchange, you need to reinvest the entire proceeds in the new property. Otherwise, the transaction is taxed normally, and you won’t be able to defer capital gains tax. However, in 1033 exchanges, you need to buy a property whose value is equal to or greater than that of the old property. The money left after the exchange is tax-free, and you can use it as you want.
All these reasons make 1033 exchanges entirely different from 1031 exchanges. As mentioned above, along with the opportunity to defer capital gains tax, a 1033 exchange also lets you purchase a property without bothering about the deadlines. As there is no Qualified Intermediary to hold the proceeds or compensation, it’s you who manages the entire fund. The best part is that you can invest your proceeds for a short time until you buy the new property. Now that you’ve become familiar with 1033 exchanges, the next thing that you should know is the requirements for doing a 1033 exchange.
1033 Exchange Requirements:
- 1033 exchanges require you to fulfill minimal requirements. The only major requirement is when you purchase a new like-kind property. In a 1031 exchange, like-kind properties include a wide variety of assets. On the other hand, a 1033 exchange requires the replacement property to be ‘similar or related in service or use’ to the condemned or lost property. In simple words, if the condemned property was a restaurant, the replacement property must also have a restaurant.
- Involuntary conversion doesn’t let you change the nature of your investment. The IRS requires you to continue your prior financial obligations through reinvestment.
Your lost property decides how much time you will get to find and acquire the new property. For investment or income-producing properties, the time limit is three years. However, the deadline is two years for all other properties. Besides, you will get four years to purchase the new property if you have lost your old property in a natural disaster. You can easily defer capital gains tax using a 1033 exchange if you fulfill all these requirements. Undoubtedly, the IRS is lenient on deadlines in 1033 exchanges as compared to 1031 exchanges.
Since involving a Qualified Intermediary in the exchange is not mandatory in 1033 exchanges, you have the full authority on over your money. Many investors who have lost their properties favor 1033 exchanges, as having control over the funds is what they prefer. After all, a 1033 exchange is a blessing for any investor who has lost their property accidentally. It is always beneficial to consult a qualified tax advisor before investing in a property, and so is the case with 1033 exchanges. You must consult a 1033 exchange expert before doing a 1033 exchange, as it will eliminate the risks involved in the investment.