1031 vs. 1033 Exchanges: What’s the Difference?
A Tale of Two Tax Codes: 1031 vs. 1033 Explained
Understanding how to defer capital gains tax is key when selling or losing your property. It can greatly impact your financial results. Sections 1031 and 1033 of the tax code allow for tax deferral. However, they apply to different situations. Here’s an easy-to-understand breakdown of how each works and why it matters for your legacy.
1031 Exchange: Voluntary Sales
A 1031 exchange comes from Section 1031 of the Internal Revenue Code. It helps property owners sell their investment or business-use real estate. They can then reinvest the money into another similar property. The main benefit? You can defer paying capital gains tax on the sale as long as you follow specific rules:
Like-Kind Requirement: The new property must be similar in nature to the one sold.
Strict Timelines: You need to find a replacement property in 45 days. Then, you must finish the purchase within 180 days.
Full Reinvestment: To defer all gains, you need to reinvest all proceeds and match or exceed the value of the sold property. Any leftover cash (“boot”) is taxable.
1033 Exchange: Involuntary Sales
A 1033 exchange applies when you lose your property involuntarily. This can happen due to eminent domain, government condemnation, natural disasters, or theft. This rule lets you delay paying capital gains tax. You can do this if you use the insurance money or compensation to buy similar property.
Involuntary Conversion: Applies only when property is lost or taken against your will, not through a voluntary sale.
Flexible Timelines: You usually have up to two years to reinvest in replacement property. In some cases, this can extend to three years for condemnation. This gives you more time than a 1031 exchange.
Similar Use Requirement: Replacement property must be similar or related in service or use to the original. The IRS interprets this broadly, but the new property should serve a similar function.
Full Reinvestment Needed: As with 1031, you must reinvest all proceeds to fully defer capital gains tax. Any unused compensation is taxable.
Why Does This Matter for Capital Gains?
Both 1031 and 1033 exchanges let you defer capital gains tax, but the eligibility and process are different. Choosing the right strategy can protect your proceeds, maximize reinvestment, and safeguard your family’s legacy.
Thinking about a sale or facing an involuntary property loss? Engage with our firm today. Our team will help you navigate these complex rules, avoid costly mistakes, and ensure your legacy is preserved.
