1033 Exchange: How to Defer Tax on a Condemnation Award

When a government agency takes your property, the payment you receive is treated much like a sale price. That can produce a taxable gain even though you never chose to sell. Section 1033 of the Internal Revenue Code exists for exactly this situation. It allows you to postpone the gain if you put the money back into replacement property within a set period.

Practitioners often call this a 1033 exchange. The name is convenient but slightly misleading. Nothing is exchanged. You receive money, you buy replacement property, and you elect to defer the gain.

What Section 1033 covers

An involuntary conversion happens when property is destroyed, stolen, seized, requisitioned, or condemned, or is disposed of under the threat or imminence of condemnation, and you receive money or other property in payment. The Internal Revenue Service describes an involuntary conversion in these terms and notes that gain is ordinarily recognized unless replacement property is acquired.

Two paths appear in the statute. If the property is converted directly into property similar or related in service or use, no gain is recognized at all. Far more commonly the agency pays cash, and the second path applies: you may elect to recognize gain only to the extent the amount realized on the conversion exceeds the cost of the replacement property you buy.

When the clock starts and when it ends

The replacement period begins on the date the converted property is disposed of, or on the earliest date of the threat or imminence of condemnation, whichever comes first. That second trigger matters. Many owners can begin looking for replacement property as soon as the agency announces the project.

The period ends two years after the close of the first taxable year in which any part of the gain is realized. Note the wording. The clock does not run from the date of the taking. It runs from the end of the tax year in which the gain first appears, which usually gives an owner more time than a plain reading of “two years” suggests.

Section 1033(g)(4) replaces two years with three years where real property held for productive use in a trade or business or for investment is condemned. Section 1033(h)(1)(B) allows four years for a principal residence converted as a result of a federally declared disaster. The Secretary may also designate a later date on application by the taxpayer, and the Internal Revenue Service publishes guidance on requesting that additional time.

What qualifies as replacement property

The general standard is property similar or related in service or use to the property converted. Courts and the Service read this narrowly for most property. A rental warehouse replaced by another rental warehouse is comfortable. A rental warehouse replaced by raw land is not obviously so.

Condemned real property receives a more generous rule. Under Section 1033(g)(1), if real property held for productive use in a trade or business or for investment is condemned, property of a like kind held for one of those purposes is treated as similar or related in service or use. Like kind is the broader standard familiar from Section 1031, and it gives owners of business and investment real estate real flexibility in choosing a replacement.

The election and your basis in the replacement

Deferral is not automatic. You elect it, at the time and in the manner the regulations prescribe, and you report the election with your return for the year the gain is realized.

Making the election changes your basis. Under Section 1033(b)(2), the basis of the replacement property is its cost reduced by the gain that was not recognized. The deferred gain rides along inside the new property and surfaces on a later taxable sale or exchange. This is a timing benefit, and a substantial one, but it is not an exclusion.

The election also affects the assessment period. If you elect deferral, the statutory period for assessing a deficiency attributable to the gain does not expire until three years after you notify the Service that you have replaced the property or that you do not intend to.

Limits worth knowing before you commit

Section 1033(i) blocks the deferral where replacement property is acquired from a related person. The restriction reaches C corporations, partnerships in which C corporations hold more than fifty percent of the capital or profits interest, and any other taxpayer whose aggregate realized gain on property involuntarily converted during the year exceeds $100,000. An exception applies where the related person acquired the property from an unrelated person during the replacement period.

Section 1033 also does not apply to stock in trade or other property held primarily for sale under the condemnation rule in subsection (g). And if the taking involves your main home, the statute cross references the Section 121 exclusion, which may cover part or all of the gain on its own terms.

Sources

• 26 U.S.C. § 1033, Involuntary conversions (Office of the Law Revision Counsel)
• Internal Revenue Service, Involuntary conversions: Real estate tax tips
• Internal Revenue Service, Involuntary conversion: Get more time to replace property
• 26 C.F.R. § 1.1033(g)-1, Condemnation of real property held for productive use in trade or business or for investment

Frequently asked questions