Acts of God and the Government – An Involuntary Exchange

If nature destroys your property, or it gets condemned and/or the government mandates eminent domain – it is considered an involuntary exchange, aka a Section 1033 Exchange.

What is an Involuntary Conversion?

An involuntary conversion occurs when your property is destroyed, stolen, condemned, or disposed of under the threat of condemnation and you receive money or other property, such as insurance or a condemnation award. Involuntary conversions are also called involuntary exchanges.¹

• Gain or loss from an involuntary conversion of your property is usually recognized for tax purposes unless the property is your primary residence.

Section 1033 allows gains realized from certain involuntary conversions of property to be deferred or recognized at the taxpayer's choice.

Typically, Section 1033 is from Eminent Domain, a Seizure of land or other property, or a casualty loss suffered from a fire, flood, hurricane, tornado, or other types of condemnation.

1031 Exchange versus 1033 Exchange

The type of replacement property in a Section 1033 exchange depends upon the nature of the condemned property. Generally, the replacement property must be similar in service or use to the condemned property under I.R.C. §1033(a) (similar-use requirement). Essentially, the replacement property must have the same or very similar functional use and purpose as the condemned property.

• If the taxpayer owned land, they may improve upon it.
• The gain on the involuntary conversion is deferred until a taxable sale or exchange occurs.¹

¹ https://www.irs.gov/businesses/small-businesses-self-employed/involuntary-conversions-real-estate-tax-tips.

This is more limiting than Section 1031's “like-kind” requirement, where all real property is like-kind to all real property. Tax court opinions have consistently explained that the reinvestment proceeds must be a reasonably similar continuation of the taxpayer's prior commitment of capital.²

² S. E. Ponticos, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent, 338 F.2d 477 (6th Cir. 1964)

Key Differences

* If not, the various tax implications are recognized.

Types of Replacement Property

• Reinvestment be made in "substantially similar" property.
• Reinvestment must be a significant continuation of the prior commitment of capital and not a departure from it.
• Character of the investment should not be changed (although the replacement property does not need to duplicate the converted property); and...
• Transaction should allow a taxpayer to return as closely as possible to the original position.³

When Must a Replacement Solution Occur?

• Two years, if the land is already owned by the taxpayer, the property may be improved typically within two years, or:
• Three years, if the taxpayer purchases a similar property for business or investment purposes.
• Four Years - for primary residences and their contents damaged (by Presidentially declared disaster areas), the replacement period normally ends four years after the close of the first tax year in which any part of the gain on the conversion is realized.⁴

³ https://www.irs.gov/pub/irs-wd/201636034.pdf

⁴ Involuntary Conversions I.R.C. Section 1033 (wm.edu)

How can CYNA 1031 Advisors help?

1033 Exchanges are typically more uncommon than a 1031 exchange. Please contact us if you need some guidance or a second opinion.