As the recognized national leader in 1033 exchanges, the Asset Preservation, Inc. (API) team knows itโs important to understand the differences between the requirements of IRC Section 1031 and Section 1033. Knowledge is power. Thatโs why we are available to provide answers and help develop 1031 exchange strategies that boost investorsโ returns and financial portfolios. We can also explain the differences between Section 1031 and Section 1033 nonrecognition of gain.
UNDERSTANDING SECTION 1033
Section 1033, much like its cousin, the Section 1031 exchange, is an IRS tax-deferral strategy. Both strategies allow investors to defer capital gains taxes. However, the circumstances and rules governing each approach vary significantly.
To understand Section 1033, an investor first needs to understand a โforced conversion.โ In short, a forced conversion occurs when an owner receives compensation after the government takes their property through eminent domain or when a natural disaster destroys the property.ย
What makes Section 1033 unique is that it offers the chance to defer capital gains taxes by reinvesting the proceeds from the compensation received for the converted property into similar property.
HOW DOES SECTION 1033 DIFFER FROM SECTION 1031?
Our clients frequently ask: what is a Section 1033 involuntary conversion? They also want to know how it differs from a Section 1031 exchange. Because we have completed thousands of these transactions, we can inform our clients regarding both tax code Sections.ย
The primary differences between Section 10311 and Section 1031 are the conditions that trigger eligibility and the flexibility offered to those who qualify.ย
First, some basics about the 1031 exchange. The 1031 exchange is generally initiated voluntarily by the investor seeking to sell an investment or business property and purchase another “like-kind” investment or business property to defer capital gains taxes. The rules surrounding a 1031 exchange are strict, especially regarding the timelines for identifying and closing on the replacement property. Another complication of the 1031 exchange is that an investor must select a qualified intermediary (QI)to hold the funds during the transaction. As a result, the exchange must be set up with the QI before the relinquished property sale closes.
Conversely, Section 1033 is triggered by an involuntary event, like eminent domain or a natural disaster. Thatโs why this option is more lenient in terms of timelines and broader regulations. For example, with Section 1033, the investor has 2-3 years from the date of the involuntary conversion to identify and invest in a replacement property.ย
There is another crucial difference between the two options. Unlike Section 1031, Section 1033 does not require a qualified intermediary to hold the proceeds from the converted property.ย
Under Section 1033, the investor can take direct control of the proceeds from the converted property until the purchase of the replacement property. Why is that important? Because it provides greater flexibility in managing the reinvestment until the replacement property is secured. It is convenient because it allows investors to hold the funds in personal accounts. An investor can even place the funds in certain other investments until a suitable replacement property is found.
The Section 1031 exchange and Section 1033 are similar in that they both require the proceeds to be reinvested into “like-kind” real estate to qualify for full tax-deferment benefits.ย
Essentially, the replacement property under Section 1033 must also be an investment. It canโt be a personal residence or vacation home. That said, Section 1033 offers a broader range for what qualifies for a replacement property. Besides the traditional “like-kind” real estate as defined under Section 1031, replacement property options could include the acquisition of a controlling interest in a corporation that owns investment real property.
SECTION 1033
An Investor may want an option to defer capital gains taxes but that doesnโt require reinvesting 100% of the equity from the converted property. Thatโs precisely where Section 1033 stands out. Why is this advantageous? First, an investor can secure favorable financing terms for the replacement property, and use a portion of the equity for other investments instead of reinvesting those funds in the replacement property.ย ย
We understand that the differences between Section 1033 and Section 1031 can be confusing. If you arenโt a financial expert, you will need some help.
For the assistance you need, contact API. Weโve been helping investors like yourself since 1990 and have the experience you need to make a smooth and beneficial 1031 exchange transaction.ย
Remember, the flexibility of the Section 1033 rules can provide significant advantages when an eminent domain proceeding or natural disaster affects your property.