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1033 Tax Library
 Caution:
The information reported in this stack only applies to involuntary
exchanges or conversions under Section 1033.
They do not apply to Section 1031
Deferred Exchanges
If you lose your
property through an "involuntary exchange", Code Section 1033 steps in
and provides relief. An involuntary exchange occurs when your property
is destroyed, stolen, condemned, or disposed of under the threat of
condemnation, and you receive other property or money in payment.
Involuntary
exchanges are called involuntary conversions. The conversion results in
the property being converted into money or other similar property such
as insurance proceeds or condemnation awards.
Involuntary
conversions of your property can result in a gain or loss. If your
"amount received" is more than your adjusted basis of the property, you
have a gain. If less, you have a loss.
If you have a
gain, you may elect to postpone recognition of the gain if you buy
qualified replacement property within a specified replacement period.
The basis of your replacement is reduced by the nonrecognized gain.
If you do not
qualify, or choose not to postpone the tax, you must report the gain.
Special rules apply to replacement of real property used in trade or
business or held for investment that is condemned or sold under threat
of condemnation.
There are no
similar deferral provisions available for losses. Losses must be
recognized in the year incurred. If you have a loss, it is deductible
only if the property was business or investment property, or if the loss
resulted from a casualty or theft. Losses from condemnations of property
held for personal use, such as your personal residence, are not
deductible.
What is an Involuntary
Conversion?
An involuntary
conversion is the involuntary or compulsory loss of your property
followed by acquisition of replacement property.
An involuntary
conversion takes place when you receive money, unlike-kind property, or
like-kind property for:
In addition,
there are special provisions applying to farming operations:
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3. The
destruction of livestock by disease or sale/exchange because of
disease.
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4. The sale of
your draft, breeding, or dairy livestock because of drought.
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5. The sale of
property lying within an irrigation project in
order to conform with the acreage limitations of the federal
reclamation laws.
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6. The
replacement of involuntarily converted livestock with
other farm property where there has been environmental
contamination.
It's usually not
difficult to determine if there has been destruction or theft of
property. Examples are hail losses, fire, lightning damage, tornado,
hurricane, and flood destruction.
Condemnations
Condemnation is
the taking of your property by exercise of the power of requisition or
condemnation or the threat or imminence of threat. It is the process by
which private property is legally taken for public use by the federal
government, a state government, or political subdivision in exchange for
a reasonable amount of money or property. You are under threat or
imminence of condemnation if a representative of a governmental body
authorized to acquire property for public use tells you they have
decided to take your property. From this, you have reasonable grounds to
believe your property will be condemned if you do not sell voluntarily.
A tax sale of your
property because of delinquent taxes is not an involuntary conversion.
In Rev. Rul.
63-221, the IRS ruled that a threat or imminence of condemnation is
generally considered to exist if you obtain information through a news
medium as to a decision to acquire your property for public use. Two
conditions must be met:
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1. You must
obtain confirmation from a representative of the
governmental body involved as to the correctness of the
published report.
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2. You must have
reasonable grounds to believe the property will
be condemned if a voluntary sale is not arranged.
To qualify as a
threat:
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1. The other
party must have the legal power to condemn or
requisition, and
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2. must make a
threat of condemnation, or there must be a known
imminence of condemnation.
A threat of
condemnation need not be a certainty - it exists if it might reasonably
be believed from representations of government agents and surrounding
circumstances that a condemnation is likely to take place.
These sales
qualified as involuntary conversions:
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1. Taxpayer sold
his property to the city under threat or
imminence of condemnation. The city leased back the property
to the taxpayer for three years.
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2. The taxpayer,
under threat of condemnation, sold an option to
the city. The option was later exercised. During the option
period, the city leased the property from the taxpayer.
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3. Taxpayer sold
the property to a party other than the threatening authority. A
private non-profit organization bought the property with the
understanding it would sell the property to the governmental agency as
soon as public funds became available. Before the sale, taxpayer was
told by the U.S. Department of Interior, that it would acquire his
property by condemnation if a voluntary sale could not be arranged.
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4. The
taxpayer's property was involuntarily converted into money. The IRS,
in Rev. Rul 88-103, said the grantor trust could buy the replacement
property and qualify the taxpayer for nonrecognition of gain under
Section 1033. The IRS said the grantor of the trust is the taxpayer
eligible to elect to defer the gain and is treated as the owner of the
entire corpus and income of the trust.
Not all
involuntary losses of property qualifies as an involuntary conversion.
These forced sales did not qualify:
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1. Condemnation
by public health or safety officials. The property was not taken for
public use.
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2. Sale of
property because of adverse business conditions.
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3. Loss of
property through foreclosure.
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4. Loss of
property because of unpaid taxes.
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5. Sale of
property to pay paving assessment.
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6. Sale induced
by extensive and recurring vandalism.
Three Requirements of Section 1033
You can choose to
postpone reporting the gain by qualifying and electing to use the
provisions of Section 1033. To do this, you must satisfy three
requirements:
Replacement Amount Requirement
. . .
To avoid
recognition of all the gain, the cost of your replacement property must
equal or be more than your net proceeds for the condemned property. Your
net proceeds are the total proceeds reduced by your expenses of securing
the award and any special assessments levied against remaining property
resulting from the installation of an improvement.
If the cost is
less, the difference is recognized as gain. Look at it this way: If the
condemnation or other award received is more than the cost of the
replacement property, the excess is treated just like boot received in a
Section 1031 like-kind exchange. It's taxable.
[p-1]
Caution: Any payments
made to third parties on your behalf out of your award are included in
your net proceeds.
[p-2]
It is not
necessary to trace the proceeds of a conversion to the replacement
assets. Nor is it necessary to deposit the proceeds of the conversion in
a separate trust or escrow account or otherwise segregate the proceeds.
The cost of
replacement property is figured in the regular way. It includes cash
paid and mortgages given.
p-3
Making the Election
You elect
nonrecognition of gain by not reporting a recognized gain on your tax
return for the year the conversion took place. You must report the
details of the conversion including a complete description of the
property, the amount of your gain and how you figured it, the kind of
conversion (fire, etc.), and a statement of your decision to replace
under Section 1033. Failure to report the gain in the year of conversion
is treated as an election of nonrecognition treatment under Section
1033.
If you report the
gain in the year of conversion, but later qualify for nonrecognition,
you may file an amended return. The claim must be filed before the end
of your replacement time period.
If you don't meet
the requirements of Section 1033, you must file an amended return for
the year of the conversion and refigure your tax.
You must report
all details of the replacement property on your tax return for the year
of replacement.
If you die after
the conversion, but before the replacement, the IRS and Courts differ on
qualifying. The IRS says you cannot qualify if the replacement of the
converted property is made by your executor or testamentary trust who
succeed to the ownership of the conversion proceeds. According to the
IRS, Section 1033 nonrecognition benefits are limited to the individual
taxpayer who held the property that was converted. However, the Third
and Fourth Circuits have held your estate can qualify.
Disaster Loss of Principal Residence
If you lose your
property from a disaster and receive other property or money in payment,
you have what is called an involuntary conversion. The conversion
results in the property being converted into money or other similar
property such as insurance proceeds or condemnation awards. Involuntary
conversions can result in a gain or loss. If the "amount received" is
more than your adjusted basis of the property, you have a gain. If less,
you have a loss. If you have a gain, you may qualify for the exclusion
provisions under
Section 121 [Up to $250,000 for singles and $500,000 for married
couples filing jointly.]
No gain is
recognized from the receipt of insurance proceeds for personal property
if the personal property was a part of the primary residence's contents
and was not scheduled under the insurance policy. In other words, the
proceeds are excluded from gross income.
Figuring Gain
Casualty and Theft
You have a gain if
you receive insurance or other reimbursement that is more than your
adjusted basis in the destroyed, damaged, or stolen property. Your gain is
the difference between the amount you receive and your adjusted basis in
the property at the time of the casualty or theft. You must use your
adjusted basis to figure the gain even if the decrease in value of the
property is more than your adjusted basis.
Any payments made to
third parties on your behalf as part of the "settlement" are included in
figuring reimbursement you receive.
2-4
The nature of the
gain (or loss) from a casualty or theft of property is determined by the
classification of the property at the time of the event. For example, gain
from a casualty or theft of depreciable property is subject to recapture
of some or all of the depreciation taken on the property.
If your insurance
recovery is for the loss of the converted property, the provisions of
Section 1033 are available. One Court permitted insurance proceeds for the
loss of the use and occupancy of the involuntarily converted property to
qualify. However, when proceeds of business interruption insurance are
received (based on lost profits, revenues, or rentals), they do not
qualify for Section 1033 treatment. They are taxed as ordinary income.
Condemnations
If your net
condemnation award is more than the adjusted basis of the condemned
property, you have a gain. Your net condemnation award is the total award
minus all expenses paid in connection with obtaining the award.
p-5
If only part of your
property is condemned, you must allocate the basis between the condemned
part and the remaining part. If the property is unimproved land, you
allocate based on original cost. If the condemned part is improved real
estate, you may use a relative value allocation based on market or
assessed values.
p-6
If you used part of
your condemned property as your home and part as a business or rental
property, you must treat each part as a separate property and figure your
gain or loss separately for each part.
p-7
Special Assessments & Severance Damages
If interest is paid
on your award to compensate you for delay in payment, it is taxed as
ordinary interest income. It is not treated as part of the award.
Sometimes the
governmental authority condemning your property will levy an assessment
against the remaining property. This assessment is usually withheld and
reduces the award you get. The assessment is made under the theory the
portion of property you retain is benefited by the improvement for which
the condemnation was made. A withheld assessment reduces the gross award
for purposes of figuring gain or loss on the condemnation.
Severance damages
are distinct from the condemnation award, They are paid for injury to the
property whereas award payments are for the property taken from you. If
you receive severance damages, figuring the gain on conversion gets very
complicated. Severance damages are compensation paid to you in addition to
the condemnation award. They are paid because part of your property is
condemned and the value of the part retained by you is decreased because
of the condemnation. Examples are impairment of access, flooding or
erosion of the property retained, replacement of fences, trees, etc., to
restore the retained property to its former use.
If severance damages
are included in the award, the amount of the special assessment withheld
must first reduce these severance damages. The balance is used to reduce
the amount of the award for the condemned property. For illustration of
how this works, see Illustration 12 later.
Condemnation
expenses must be allocated between the severance damage
payments and the condemnation proceeds. Net severance damage payments is
applied to reduce the basis of the retained property. If the payment is
more than the basis, the difference is realized gain. This gain qualifies
for nonrecognition under 1033.
Replacement Time Period
Start Up Discussion
To avoid reporting your gain from
a condemnation, you must buy qualified replacement property within a
certain period of time. This is called the replacement time period and it
ends 2 years after the close of the first year in which any part of your
gain on the conversion was realized.
The replacement time period
starts on the earlier of these two dates:
1. The day you dispose of the
condemned property, or
2. The first day the threat or imminence of condemnation started.
Special Rule of Certain
Real Estate
For real estate used in a trade
or business or held for investment, the replacement time period is
extended one year. It ends three years after the close of the first tax
year in which any part of the gain on the condemnation is realized. Dealer
property does not qualify for this extra year.
The replacement property must
exist before your replacement time period runs out. In Rev. Rul. 56-543,
the IRS ruled an advance payment made to a contractor for construction of
replacement property, where the property did not exist prior to expiration
of the replacement period, was not a purchase of replacement property.
Extensions of Replacement Time
Period
It's possible to get an extension
of time if you apply before the end of your replacement time period.
However, you must show reasonable cause for not making the replacement
during the regular period. The high market value or scarcity of
replacement property is not a sufficient reason for granting an extension.
If you are constructing the replacement property, and clearly show the
replacement cannot be made within the replacement time period, you can get
an extension.
Replace Property Before Condemnation
It's OK to acquire your
replacement property before the actual condemnation takes place. To
qualify, you must do it after there is a threat of condemnation and you
must hold it at the time of the condemnation. Property acquired before
there is a threat of condemnation does not qualify as replacement
property.
Involuntary Conversion of Your Home
You may elect to treat the gain
on the conversion of your primary residence as an involuntary conversion
or as a voluntary sale.
If you qualify for the Section
121 exclusion, you can elect to exclude all the gain up to $500,000
(married filing jointly or $250,000 single) no matter which treatment you
choose.
Replacement Property
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Start Up Discussion.
To qualify for
Section 1033 treatment, your replacement property must be similar or
related in service or use to the property it replaces.
For real estate used
in your business (including rental income property) or held for
investment, a special "like-kind" rule applies. It only applies to real
estate converted as a result of actual or threatened condemnation and is
discussed later, after our discussion of similar or related in service or
use.
If the property is
converted directly into property similar or related in service or use,
nonrecognition of gain is mandatory. For example, you exchange the
property for qualified property of like-kind and qualify under Section
1031 for nonrecognition of gain.
Paying off or
reducing a mortgage indebtedness on business property with condemnation
proceeds from adjacent business property is not a qualifying expenditure
under Section 1033 rules.
Similar in Service or Use
The meaning of
similar in service or use depends on whether you are an owner-user or
owner-investor of the property.
If you are an
owner-user, similar in service or use means the replacement property must
function in the same way as the property it replaces. The IRS takes an
extremely narrow view of the similar use requirement. It doesn't consider
property similar or related in service or use unless the physical
characteristics and the end uses of the two properties are closely
similar. For example, owner-users of a manufacturing plant must reinvest
in a replacement property having the same end use - another manufacturing
plant. A warehouse, for example, would not qualify.
In Rev. Rul. 76-319,
the IRS ruled a billiard center did not qualify as replacement property
for a bowling alley destroyed by fire.
If you are an
owner-investor, similar or related in service or use means that any
replacement property must have the same business purpose and relationship
of services to you as the property it replaces. You must determine:
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1. Whether the
properties are of similar service to you.
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2. The nature of
the business risks connected with the
properties.
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3. What the
properties demand of you in the way of management,
services, and relations to your tenants.
The most common
example of similar or related in service or use is rental income real
estate replaced with other rental income real estate. If you own the
property and rent it to a tenant, the similar or related in service or use
test is applied to you - not the tenant. The use of the properties by the
tenants can be different - they do not have to be similar.
p-14
In S. E. Ponticos,
Inc., (CA-6) 338 F. 2nd 477, capital gain realized on the condemnation
of an industrial warehouse was not recognized because the proceeds were
invested in a residential apartment house. The two properties were similar
or related in service or use.
Special Rule for Certain
Real Property
A special rule
applies to the replacement of real property used in your business or held
for investment converted as a result of actual or threatened seizure,
requisition or condemnation. The term "real property" as used here means
land, and generally anything erected on, growing on, or attached to the
land. The special rule does not apply to dealer property.
Under this special
rule, conversion of real property into "property of like-kind" to be held
for either business use or investment is considered a conversion into
property "similar or related in service or use" and qualifies for Section
1033 treatment. This more tolerant like-kind test is the same as not
included in Section 1031 exchanges before any proposed changes under the
1989 Tax Act.
Like-Kind Property
Under the special
real property rule, like-kind property means real property in almost all
cases. It does not matter if your condemned property or your replacement
property is improved or unimproved. You should consider the nature and
character of each property. The IRS treats the following as like-kind
property if held for use in business or for the production of income:
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1. Easements.
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2. Rights-of-way.
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3. Leaseholds for
a term of 30 years or more. The term includes
the initial term of the lease and all optional renewal
periods.
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4. Perpetual water
rights, if they are considered real property
rights under state law.
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5. Any similar
continuing interests in real property.
Corporate Stock as
Replacement Property
It is not necessary
to make a direct purchase of the qualified property. You can qualify by
buying stock in a corporation owning qualified replacement property.
However, you must buy a controlling interest. The term control means
ownership of 80% or more of the total combined voting power of all classes
of stock entitled to vote and 80% or more of the total number of shares of
all other classes of stock of the corporation.
It's OK to form a
new corporation to acquire the replacement property. However, the
qualified replacement property must be owned by the corporation at the
time you get control of the corporation.
Improving
Property Already Owned
The IRS has sent out
mixed signals regarding the replacement of unimproved land with improved
property meeting the like-kind test. But they have accepted the
reinvestment of net awards into property already owned as long as the
like-kind test is met. They have agreed a qualifying replacement was made
where the taxpayer reinvested proceeds from condemnation of a
manufacturing plant's land and facilities were used to rearrange the plant
facilities on the remaining land and to build a garage on land already
owned.
One important tax
case permitted the taxpayer to reinvest the proceeds from condemned
property in improvements to property already owned. [Davis
v. United States, 411 F. Supp. 964 (aff'd, 589 F.2d] 446.
Davis's agricultural
land was condemned. He reinvested the net award proceeds with physical
improvements including a water system on industrial land already owned.
The Court said the replacement of unimproved property with improved
property satisfied the like-kind test. And it agreed the reinvestment in
improvements on property already owned satisfied the replacement property
qualification.
[6 Ex}
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