Turn Involuntary Conversions Into Tax Savings With Section 1033 Exchanges

Change can often arrive without warning. Whether it is due to eminent domain or the destruction caused by a natural disaster, property owners may find themselves facing an involuntary conversion.

Although these events can be disruptive, they also present a significant tax deferral opportunity through a Section 1033 exchange. Understanding and planning for a Section 1033 exchange is essential to preserving capital, deferring tax liability, and strategically repositioning assets.

What is a Section 1033 Exchange?

Section 1033 of the Internal Revenue Code allows taxpayers to defer capital gains tax when property is involuntarily converted, such as through condemnation, seizure, or destruction, and the insurance or sales proceeds are reinvested in qualified replacement property within specific timeframes.

Unlike Section 1031 exchanges, which require simultaneous identification and exchange processes, Section 1033 offers greater flexibility:

• The replacement period is up to two years, or three years if the property was condemned or taken by a governmental agency. This period typically ends two years after the close of the first tax year in which any part of the gain from the conversion is realized.
• No qualified intermediary is needed for the Section 1033 transaction. Proceeds can be held directly by the taxpayer, offering more control over reinvestment decisions.
• The qualified replacement property must be similar or related in service or use to the affected property. While this requirement applies to many Section 1033 transactions, real estate converted due to condemnation or eminent domain can benefit from the more generous “like-kind” requirement applicable to Section 1031 exchanges. For example, although exchanging an improved piece of real estate for raw land may not satisfy the “similar use” requirement, it may satisfy the “like-kind” requirement.
• There is no limit on using debt to acquire the replacement property. For example, if a building owned free and clear is destroyed by fire and insurance pays $10,000,000, the owner can defer all of the gain by purchasing another building for $10,000,000, paying 30% down, and financing the rest. The real estate investor pulled $7,000,000 cash out of the deal ($10,000,000 proceeds less $3,000,000 downpayment = $7,000,000), but does not recognize any gain from the conversion. In a Section 1031 exchange, the investor would recognize gain up to the amount of cash taken out of the deal.

Planning techniques for 1033 Exchanges

• Timing is everything. Determine the deadline to acquire replacement property and make plans to timely acquire the replacement property.
• Choose your replacement property wisely. While proceeds can be reinvested in different asset types that serve a comparable business purpose, it is recommended to avoid rushing into an acquisition just to defer a gain.
• Tax-deferred treatment is generally optional. Use scenario planning to compare a Section 1033 exchange with a taxable disposition. Consider state-specific tax consequences and depreciation recapture.
• Depreciating replacement property. Careful consideration should be given to the method in which property acquired following an involuntary conversion is depreciated. Any gain deferred via Section 1033 reduces basis in the replacement property, and some — if not all — of the replacement property basis may be ineligible for Section 179 expensing or bonus depreciation.

Case study: Urban office displacement becomes strategic portfolio upgrade

A real estate owner held a multi-tenant office property in a growing urban corridor. The local municipality initiated eminent domain proceedings to acquire the property for a public transportation project, resulting in a $10 million condemnation award.

Instead of recognizing taxable gain, the owner utilized a Section 1033 exchange to acquire two suburban flex-office assets within the three-year replacement window. The reinvestment allowed for improved cash flow, portfolio diversification, and capital preservation, all without triggering a gain.

By working closely with a professional services firm and legal counsel, the owner navigated the technical requirements of Section 1033 while using the unexpected displacement as an opportunity for long-term strategic repositioning. By acquiring the replacement property within the requisite time frame and having documentation to support the threat of condemnation, the taxpayer was able to effectively carry out their nontaxable involuntary conversion.

How CLA can help: Turning the unexpected into a win

Section 1033 can be a silver lining in otherwise disruptive situations. But successful outcomes depend on intentional actions, planning, and sage guidance. If you experienced an involuntary conversion or want to proactively plan for one, CLA can help. We can help you assess options, navigate tax rules, and develop a strategy that aligns with your broader real estate and investment goals.