United States tax code sections 1031 and 1033 are sometimes confused by taxpayers as they are similar, not only in section number, but in that they were both created to provide for tax deferral of depreciation recapture and capital gains on the sale of property, but that's where their similarity ends. 1031 exchange and 1033 exchange differ materially in:
- Types of transactions they address
- Type of property that can be acquired
- Timeline requirements
Section 1033: Involuntary Conversion
Section 1033 of the tax code provides for the deferral of gain that is realized from an "involuntary conversion." Such a conversion includes property that is destroyed in a casualty, property that is lost due to theft and property that is transferred as the result of condemnation or the threat of condemnation.
Section 1033: Direct and Indirect Conversions
With a conversion into replacement property in a 1033 exchange, any gain related to the involuntary conversion is deferred if the conversion involves property considered similar in related service or use. That is, the use of the replacement property must be substantially similar to that of the relinquished property. This is considered a direct conversion. With a condemned property, the replacement property must be considered like-kind, a standard similar to that of Section 1031.
A 1033 conversion may also be indirect – with gain triggered on the amount converted into cash or dissimilar property. Partial deferral of gain in an indirect conversion is elective, and the taxpayer must take certain steps and meet certain criteria in order to defer gain in an indirect conversion. Most importantly, the cost of the qualifying replacement property must be equal to or greater than the amount realized at conversion. Falling short of the replacement cost will trigger gain recognition to the extent of the underinvested portion. Acquisitions from related parties can also trigger gain recognition.
Section 1033: Timelines
Generally, replacement property in a 1033 conversion must be acquired within two years of the end of the tax year in which the gain was realized, though some conversions can result in three, four and five-year replacement periods.
1031 Like-Kind Exchanges
Unlike 1033, tax code Section 1031 is specific to the voluntary reinvestment of gain from the sale of investment or business use property. In the case of a 1031 exchange, any gain related to the disposition of property is deferred if the replacement property is considered similar in nature and character. This is true both in the case of real property and personal property. The quality or grade of the replacement property is of no consequence in a 1031 like-kind exchange, only that the property is of the same nature, character, or class. In fact, most real estate is considered like-kind to other real estate.
Gain recognition is triggered in a 1031 like-kind exchange if the cost of replacement property is less than the amount of gain from property that is relinquished. Gain recognition would also be triggered in the event that the taxpayer receives property that is not like-kind to the relinquished property. Finally, as in the case of a 1033 conversion, acquisitions from related parties can trigger gain recognition. Learn more about this in “1031 Tax Deferred Exchanges between Related Parties.”
Section 1031: Timelines
In order to defer gain in a 1031 exchange, the taxpayer must acquire like-kind replacement property by the earlier of 180 calendar days or the due date of the taxpayer's next income tax return.
Summary Tax Code Sections 1031 and 1033
Section 1031 and 1033 are both powerful tax deferral strategies, but they differ substantially in their usage. Section 1033 is tax deferral specific to the loss of property by a taxpayer and is therefore is referred to as an involuntary conversion. Section 1031 is the voluntary replacement of either real or personal property in an exchange of business or investment assets. Finally, while Section 1031 generally requires the use of a qualified intermediary, Section 1033 does not.