What is a 1033 Exchange?
Intro to 1033 exchange
The 1033 Exchange allows a property investor to waive capital gains taxes incurred in selling properties. 1033 applies to property subject to involuntary conversion, that is, property condemned for eminent domain or unforeseen natural disasters. Currently, Section 1033 allows for the exchange of similar property and deferral to capital. Compared to its corresponding 1031 Exchange, which offers an investor the ability to avoid taxation while releasing a controlling share in an entity held mainly for business and investment purposes.
The money earned by the non-voluntarily converted – i.e. government or other compensation payments – may be distributed to investors directly by a 1033 exchange. There are no intermediaries required in any way. This money is available even in short-term investing until the funds in a replacement property close. However, risky investments can cause difficulty in completing the exchange process. You cannot utilize your investment loss during the exchange period to purchase your replacement asset. This should ensure that the money remains secure throughout the 1033 exchange period.
1031 exchanges are 180 days. In contrast, the 1033 exchange period gives a longer timeframe. It is generally 2 years. In the event that property is used for the production of goods or for investment (such as rental property or offices), the replacement period is extended to 3 years. In case of property destruction in Federally declared Disaster Areas, the replacement term extends to four years. The first day of the 1033 exchange replacement property is determined by the earlier date when the property was destroyed.
A replacement property under the 1033 exchange must be “similar to or connected to its use” and the property should be physically similar to the converted property, but it must have the same uses. If you have an apartment you're going to lose, you have no option of replacing this home with your own. Replacements do not change the value of the investment. For example, an asset subject to the net lease is unlikely that it will have to replace that property. In general, the IRS is strict in addressing such conditions. Nevertheless, the exceptions are minimal.
Type of Replacement Property
While a 1031 exchange requires the purchase of a replacement property ascribed to a similar type to the surrendered property, a 1033 exchange requires the purchase of an alternative property similar to or related to the lost asset for a replacement. Although they're the same, the 1033 exchange requirements are much stricter in the respect of the same property serving the same purpose for the exchanger. For example, the lost property may be the exchanger's primary home, so the replacement property will also be a new primary home.
Funds may be invested in the Short-Term
The funds can be used to make other short-term investments before completing the 1033 exchange transaction. Note that any investors that lose money in the time period of conversion or exchange can not offset the 1033 capital requirement. The 1033 exchange must use at least all the totals of the converted currency. Many investors are reverting to safer methods of protecting their assets as they complete their exchange.
Safe short-term investments
High-yield savings account
Short-term corporate bond funds
Money Market Account
Short-term U.S. government bonds
No-penalty certificates of deposit
Qualified intermediary Not Required
For a transaction involving a taxable property, the use of a certified agent for the transaction is a requirement for the success of the transaction as the investor must take no physical possession or constructive possession of any of the cash. Despite this, the 1033 swap does not require any qualified intermediaries. A businessman can take money received and put them in his personal bank account.
Qualified Intermediary Use
A 1033 exchange is unlike a 1031 exchange that requires no intermediary. Instead, the compensation derived from destroying the loss of property will remain on the exchanger until replacement property equal to the compensating proceeds is acquired.
1033 Exchange - Defer Capital Gains Taxes
1033 exchange allows property owners to defer capital gains taxes. This means the money earned from selling the property will be completely tax-free.
Does Primary Residence Qualify for 1033 Exchange?
Unfortunately, 1033 exchanges are not for every property owner, which excludes your personal property. 1033 exchange is only accepted for investment property. The qualified replacement property must be like-kind property with similar characteristics. Replacement property doesn't have to be in the same asset class, but both properties must be used for investment.
Summary of 1033 Exchange
1033 exchange is a valuable tool to defer tax when a taxpayer loses property because of a casualty or condemnation. A 1033 exchange addresses involuntary conversion of real estate either through the condemnation of the real estate by a government entity using its eminent domain authority known as taking the property for the public good or through the partial or total destruction of the real estate by a natural disaster such as fire, flood, hurricane, etc. where insurance proceeds are received. These two scenarios are both considered involuntary conversions that the real estate owners could not foresee any intermediary necessary.
Unlike a 1031 exchange, a 1033 exchange does not require a qualified intermediary at any point throughout the transaction proceeds received from an involuntary conversion do not have to be held by a third party as they do for a 1031 exchange. The real estate owner can take immediate possession and control of the funds in a personal account, money market, and investment accounts.
The real estate owner has two years to reinvest the proceeds into a like-kind property if the involuntary conversion was the result of a natural disaster and three years to reinvest if it was a condemnation. In order for a 1033 exchange to be considered complete, a like-kind purchase must take place and the title must be passed to the investor before the exchange deadline is up.
A 1033 exchange is completed most often with the reinvestment of the forced conversion proceeds into a like kind of investment real estate. Like-kind simply denotes that investment real estate must be exchanged for investment real estate.
1033 exchange is a very useful tool and lessens the risk for property owners. Hopefully, you never have to use it as an investor, but at tough times it will surely help you come over the cause of not losing your investment and receive a new investment property in return,