A 1031 exchange and a 1033 exchange are both tax-deferral strategies related to the relinquishment of business or investment real estate and both are allowed under the Internal Revenue Code (IRC) of the United States. However, they each have unique applications that apply to different situations.

1031 Exchange:

Whenever you voluntarily sell business or investment property, you generally have to pay taxes on any capital gains realized at the time of sale. You will also have to pay taxes on any depreciation deductions you have taken over the life of the investment (see also Depreciation Recapture).

IRC Section 1031 allows you to postpone paying these taxes if you reinvest the proceeds in similar property as part of a qualifying “like-kind” exchange.

Per the IRS, replacement properties are considered “like-kind” if they’re of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether they’re improved or unimproved.

The replacement properties must also be held for “productive use,” meaning that they need to be held for business or investment purposes. Additionally, real property in the United States is not like-kind to real property outside the United States.

Besides the need to pay attention to what qualifies as “like-kind,” there are specific rules and timelines that must be followed in a 1031 exchange, including:

  • Sellers must not take “constructive receipt” of sales proceeds but, instead, direct those funds to a qualified intermediary who can accommodate the 1031 transaction.
  • Replacement property must be identified within 45 days.
  • Replacement property must be purchased within 180 days.
  • The exchangor should be the same title holder and taxpayer.

1031 Equal and Up Rule:

  • Replacing equity – The equity in the replacement property must be greater than or equal to the amount of equity in the relinquished property. Equity cannot be replaced by adding debt.
  • Replacing debt – The value of debt on the replacement property must be greater than or equal to the amount of debt on the relinquished property. Debt can be replaced by adding cash.

1033 Exchange:

When an owner has an involuntary sale or “conversion,” they may look to utilize a 1033 exchange.

The 1033 exchange applies to situations where property is destroyed, stolen, condemned, or seized (eminent domain) and the owner receives compensation or insurance proceeds as a result.

Just like section 1031, a 1033 exchange allows the taxpayer to defer the recognition of any gain from an involuntary conversion if they replace the relinquished/lost property with property that is “substantially similar” or “related in service or use” to the property that was destroyed, stolen, seized, or condemned.

“Substantially similar” is not precisely defined in the tax code but generally means that the replacement property should be similar in nature or function to the property that was lost. It is a more rigid standard than the more loosely defined “like-kind” standard in section 1031.

Further, there is a distinction made between an owner-user and an owner-investor when it comes to a property that is “substantially similar”.

For example, an owner-user of a bowling alley would likely have to replace an involuntarily converted property with another bowling alley or something “substantially similar”. Whereas an owner-investor, whose relationship to the business may be more passive, may rely on the standard that more closely resembles the like-kind standard of section 1031. See also: Rul. 64-237, 1964-2 C.B. 319

There is an exception as it relates to the involuntary conversion of real estate due to condemnation. In a condemnation scenario, the replacement property rules also resemble the like-kind rules found in a 1031 exchange.

Additional rules and timelines related to a 1033 exchange:

  1. Instead of 45 and 180 days in a 1031, 1033 exchangers often have 2-4 years to complete their exchange.
    • Casualty or theft: The property must be replaced within a period of two years after the end of the first taxable year in which any part of the gain is realized.
    • Eminent domain: The property must be replaced within three years after the end of the first taxable year in which any part of the gain is realized.
    • Declared disaster zone: if the taxpayer has lost property in a Presidentially declared disaster, the taxpayer receives a two-year extension on the replacement period, a total of four (4) years in which to replace the lost property. (See IRC Section 1033(h)).
  2. No need for a Qualified Intermediary.
  3. Relinquished property proceeds can be otherwise invested until the replacement property is purchased.

1033 Equal and Up Rule:

  • Replacing equity – The COST of the replacement property must be greater than or equal to the amount of net proceeds of the relinquished property. Equity CAN be replaced by adding debt.
  • Replacing debt – The value of debt on the replacement property must be greater than or equal to the amount of debt on the relinquished property. Debt can be replaced by adding cash.

Unlike a 1031 exchange, a 1033 would allow an investor to increase the debt on the replacement property and cash out the difference.

Example:

  • Relinquished property net proceeds: $1,000,000
  • Outstanding debt on relinquished property: $0
  • Replacement property loan-to-value: 50%
  • Taxpayer invests $500,000 of cash and finances the other $500,000.
  • Total replacement value: $1,000,000.
  • Cash to the investor: $500,000.
  • Tax-deferral: 100%

While both 1031 and 1033 exchanges provide tax deferral benefits, they are used in different situations. A 1031 exchange is for voluntary exchanges of similar properties to defer capital gains tax, whereas a 1033 exchange is for involuntary conversions due to events like destruction, theft, or condemnation to defer tax on the replacement property.