§1031 Exchange & §1033 Conversion Basics
An Internal Revenue Code Section 1031 exchange is an IRS authorized process where like-kind business or investment property is exchanged without immediate tax consequences. This type of exchange is most commonly used for real estate transactions; however, other depreciable assets (office equipment, cars and aircraft) and non-depreciable and intangible assets (some patents, software, and trademarks) may qualify for exchange as well.
IRC Section 1033, Involuntary Conversions, is available when a property is completely or partially lost due to fire, natural disaster, theft, seizure or condemnation, including the disposition of the property upon threat or imminence of condemnation or eminent domain. §1033 allows for non-recognition of tax if the injured property is timely replaced with property of similar character or quality.
Why Consider a §1031 Exchange?
Property that is sold or transferred at a gain can be subject to taxation. Those taxes can add up quickly depending on the type of property, how long it was owned, state taxes, other capital gains, depreciation and the owner’s tax bracket. As a property seller, you may be liable for taxes that add up to 40% or more.
As a property owner or business owner, the §1031 exchange is a powerful investment tool. A §1031 exchange gives the exchanger the ability to keep all of the property’s equity for re-investment, allowing the exchanger the opportunity to acquire a replacement property with better cash flow, less management, a more desirable location and other such investment goals.
Why Consider a §1033 Conversion?
If cash is received in a §1033 involuntary conversion and the property owner does not replace the injured property fully with similar property, the owner will be subject to taxation, both federal and state. After months or even years of arguing over the taking of a property, the owner can be faced with the untimely taxation of the proceeds. This can be financially disrupting if the property has been held for a long period of time and/or the basis is very low.
Replacement Period and Restrictions
§1031 exchanges must be completed within 180 days, yet can have very broad replacement property choices. The IRS requires a neutral third party, known as a facilitator, qualified intermediary (QI) or accommodator to be used for facilitating a deferred or indirect §1031 exchange.
The time period for replacing a §1033 conversion is up to three years in the case of a condemnation or two years for reasons other than condemnation. A §1033 conversion does not require the engagement of a third party to facilitate the transaction; the owner can receive the proceeds of the sale directly as long as they are reinvested according to the rules within the prescribed time frame.
For both §1031 and §1033, there are restrictions on the acquisition of replacement property from a related party.
A number of exceptions are available for a §1031 exchange that are not available for taxpayers suffering an involuntary conversion under §1033. The most important exception is that replacement property can be acquired from a related party if both the relinquished and replacement property are held by the taxpayer and the related party for at least two years.
Need More Information?
We believe it is important for our clients to understand the processes they are about to go through before they actually begin. This material is only intended to provide a basic understanding. Please contact a Boulay tax advisor to review your situation and determine how these rules may benefit you.