Understanding the Key Differences Between a 1033 Exchange and 1031 Exchange
According to IRC Section 1031, a 1031 Exchange is a transaction which allows a tax payer to exchange one property for another by deferring the tax consequence of a sale. No gains or loss shall be recognized on the exchange of such a property.
What is a 1033 Exchange
Similar to the 1031 Exchange, the 1033 Exchange allows an investor to defer tax on capital gains while relinquishing control of a property held for business or investment purposes. When you lose property through a casualty, theft or condemnation, Section 1033 exchange applies and you realize gain from insurance or condemnation proceeds.
1031 Exchange Vs. 1033 Exchange
Both Section 1031 and Section 1033 achieve the same outcome of deferring capital gain taxes when selling real property, however 1033 does not have as strict regulations as a 1031.There are certain differences between the two sections. These are:
In 1031, exchange of property is held for productive use in a trade or business or for investment. But in 1033, exchange of property is compulsorily or involuntarily converted as a result of eminent domain, destruction or theft. Equity in the replacement property in a 1031 exchange must be equal to or greater than the net equity of the relinquished property. Whereas, in a 1033 exchange, cost of the replacement property must be equal to or greater than the net proceeds received.
The Value of Debt
The value of debt on the replacement property of a 1031 exchange must be equal to or greater than the value of debt relieved on the relinquished property. In case of 1033 exchange, the value of debt on the replacement property must be equal to or greater than the value of debt relieved on the property converted. To be able to exchange a property through 1031, the property should be like-kind property whereas; in a 1033 exchange a property exchanged can be similar or related in service or use. Exchange funds cannot be used to improve land already owned in a 1031 exchange whereas conversion proceeds can be used to improve land already owned in a 1033 exchange property.
What Are 1033 Exchange Guidelines?
Just like a 1031 exchange, 1033 guidelines require an investor to reinvest proceeds from a forced conversion into a like-kind real estate exchange to qualify for full tax-deferment benefits. But the tax deferral provisions and timelines of a 1033 exchange are much more lenient and liberal to the tax payer compared to a 1031 regulations and stipulations. Generally, for an investor to successfully complete a 1033 exchange, they should be aware of the type and value of assets that qualify for exchange and the timelines involved in completing an exchange.
A 1033 exchange is completed most often with a reinvestment of the forced conversion proceeds into “like-kind” investment real estate. “Like-kind” simply means that investment real estate must be exchanged for investment real estate. Personal residences and vacation homes that are not utilized primarily as rentals are not “like-kind” to investment real estate and do not qualify for a 1033 exchange. In a 1033 exchange, an investor has other options in addition to “like-kind” real estate and can select 80% control of a corporation owning replacement property to complete a successful exchange.
When Is A 1033 Exchange Considered Complete?
The 1033 exchange gives investors anywhere from two to three years from the date of the eminent domain or other forced conversion to close on replacement, like-kind real estate to complete the exchange. There is no identification requirement in Section 1033, which means the investor can select any number or combination of assets to complete a 1033 exchange. Also, for a 1033 exchange to be considered complete,there must be an actual purchase and title must be passed to the investor before the exchange deadline.
Losing your property because of a natural disaster is terrible, but it would only make things worse if you incur tax liability. Section 1033 of IRC helps taxpayers avoid paying taxes because of unintentional conversions. It is always better to consult a tax professional to understand the tax implications of any exchange.
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