Deferral Strategies Under Section 1033

Topics: Capital Markets/Commercial Real Estate

Natural disasters can wreak havoc on properties, leaving individuals and businesses with significant financial losses. Each year, we bear witness to yet another out-of-control wildfire that devastated a community or another destructive hurricane. In the aftermath of such disasters, property owners often struggle to find relief. One valuable tool that can assist taxpayers is Internal Revenue Code (IRC) Section 1033, which allows for the deferral tax on gains for involuntary conversions of property due to such events.

The IRC Section 1033

Property owners may not realize that funds received as a result of insurance proceeds typically triggers a recognition of capital gains. IRC Section 1033, similar to Section 1031, allows taxpayers to defer recognition of gain on involuntary conversions of real estate.

Section 1033 provides that the gain that would result on the receipt of insurance or other compensation due to involuntary conversion of real estate is deferred if the amount realized (net of legal, appraisal and other expenses) is reinvested in real property similar or related in service or used on the converted real property.

Unlike a Section 1031 transaction, the rules under Section 1033 do not require the use of a qualified intermediary or adhere to mandatory timelines. The property owner reports the details of the replacement property in a statement attached to his or her return for the year in which the replacement property is acquired.

The specific operation of Section 1033, including the rules on the types of real property that qualify as similar or related in service or use, and the time period during which such property must be acquired, depends in part on whether the real property was subject to a natural disaster.

Property owners have two years from the end of the year in which the natural disaster occurred to acquire their replacement property.

Real-World Application

Consider a scenario where a business's warehouse is destroyed by a hurricane. The insurance proceeds cover the market value of the property, resulting in a significant gain over the original purchase price. Under normal circumstances, the business would be required to pay capital gains tax on the gain over the original purchase price. However, by utilizing Section 1033, the business can defer this tax by reinvesting the proceeds into a new warehouse or similar property within the designated period.

This deferral is crucial for maintaining cash flow during the recovery phase, allowing the business to restore operations more swiftly and efficiently. Additionally, the flexibility in selecting replacement property means the business can potentially improve its facilities, leading to long-term benefits.

Condemnation: Another Section 1033 Opportunity

Condemnation is another aspect of IRC Section 1033 that’s important for property owners to understand. Condemnation can include the following:

  1. Condemnation under power of eminent domain is when a property owner has lost property because the government wishes to take or has taken the property; or
  2. Imminence of condemnation is when the property owner sells a property due to knowledge of a threat of condemnation and reasonably believes that a condemnation is likely to occur.

In cases where real property held for investment or for use in a trade or business (excluding property held primarily for sale) is condemned under power of eminent domain or sold under threat or imminence of condemnation, Section 1033 applies Section 1031 like-kind guidelines to determine whether the new real property is qualified replacement property.

Property owners have three years from the end of the year in which the condemnation occurred to acquire their replacement property.

IRS Section 1033 offers a valuable tax deferral opportunity for property owners affected by natural disasters like hurricanes and wildfires. By deferring the recognition of gain from insurance proceeds, property owners can reinvest in replacement property and focus on rebuilding their lives and businesses. Understanding the specifics of this provision and leveraging the extended replacement periods available in disaster scenarios can provide significant financial relief and facilitate a smoother recovery process, thus being informed about such tax provisions becomes increasingly essential.

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