Basics of Section 1033 Involuntary Conversions

December 24, 2018

As we’ve seen by examining Sections 1031 and 368, and other topics, the tax world is full of rules. If someone wants to pursue a career related to tax, he or she should definitely be comfortable following rules. In essence, the U.S. tax code is a vast web of rules.  They build on each other and create an immensely complicated, interlocking system. Mastering every piece of this gigantic puzzle is beyond the reach of any mere mortal.  That’s why all tax professionals end up specializing in one or a few areas.

We have a simple goal for this blog.  That is to acquaint readers with various tax topics so they can take better advantage of the code.  They can also then competently seek assistance with their tax related issues. We also want to encourage readers to reach out to us whenever they need counsel in an areas we work with. 

The Forcible Liquidation of Private Property

Within the code, there’s no question that certain sections are more useful than others. We’ve shown that the provisions of Section 121, for instance, can be extremely valuable for homeowners.  Many invoke this section to eliminate substantial capital gains. Section 1033 is yet another section which should be ranked among the more valuable sections for property owners. Section 1033 deals with “involuntary conversions”.  That is, forcible acquisitions of private property by government entities.

When a government entity forcibly takes a property from a private citizen, this taking is lawful.  Lawful, that is, as long as that private citizen receives adequate compensation. Section 1033 lays out the rules pertaining to the taxability of gains associated with such compensation.  Like Section 1031, Section 1033 allows for tax deferral of gains.  It does so for gains associated with involuntary conversions under certain conditions. This makes intuitive sense.  That’s because deferral should be available when the taxpayer didn’t necessarily desire to relinquish ownership of his or her property. 

In this post, we’ll first introduce readers to the concepts behind Section 1033 involuntary conversions.  Thereafter, we’ll discuss a hypothetical example of tax deferral following a conversion. 

Basic Rules of 1033 

Section 1033 has many subtitles and subparagraphs.  Its quite a bit more complicated than the main paragraph of Section 1033.  That is to say, the main paragraph, not including the Treasury Regulations.  Some of these subtitles touch on very narrow issues involved with involuntary conversions.  For instance, subtitle (f) deals with replacement of livestock.  Subtitle (h) lays out special rules for property destroyed or damaged in presidentially declared disasters. In future blogs, we may come back and touch on some of these more narrow provisions. For now, though, let’s just focus on the most important aspects of 1033.  

The General Rule

The ”general rule” of Section 1033, is laid out in subtitle (a).  It states the circumstances under which gains which results from compulsory or involuntary conversions of property will not be recognized.  Those circumstances are those in which taxpayers receive similar property, or use funds received as compensation to acquire similar property. Paragraph (1) of subtitle (a), therefore, describes a situation which is essentially identical to a “direct swap exchange” under Section 1031.  In this scenario, the owner of the property which is involuntarily converted receives another property instead of money.  And just like with a Section 1031 direct swap, since no money is received, no gain is recognized.  

The Impact of Acquiring Cash or Stock

Paragraph (2) gives rules for the deferral of gain in situations involving cash proceeds received by property owners. As one would expect, these rules operate in a manner very similar to the rules of Section 1031.  As long as property owners spend all of the proceeds they receive, they will not recognize any gains associated with the involuntary conversion. However, if property owners choose to keep some or all of the cash proceeds, then they will incur a taxable consequence.  The taxable portion equals the amount of their gain.

Perhaps the biggest difference between Section 1033 and Section 1031 has to do with eligible replacement property. Under subparagraph (A) of paragraph (2), Section 1033 provides that taxpayers may acquire stock in a corporation which owns similar property in order to defer gain associated with the conversion. This would not be permissible under Section 1031.  That’s because stock is not considered to be of like-kind to real estate under any circumstance.  

Timing Requirements

Another big dissimilarity between Section 1031 and Section 1033 has to do with the time allowed to acquire replacement property. Under subparagraph (B) of paragraph (2), taxpayers will have two years to acquire property after the close of the taxable year in which any gain is realized.  This means that taxpayers can have close to three years to obtain property, depending on the timing of the receipt. This is substantially longer time period when compared with the 180 day requirement imposed by the Treasury Regulations for a delayed 1031 transaction. In an involuntary conversion, the time clock begins when the original property is either converted, threatened with condemnation or sold or exchanged as a consequence of such a threat.  

Hypothetical 1033 Involuntary Conversions

Let’s take a quick look at an example of a Section 1033 transaction. Suppose a taxpayer owns a commercial building with a basis of $600,000 and a current fair market value of $1 million. The taxpayer has this property involuntarily converted.  In the conversion, the taxpayer receives compensation in the form of $1 million in cash. The taxpayer receives these funds during the month of October upon property conversion. At the close of the tax year, this taxpayer has two years to acquire similar property in order to defer the gain associated with the converted property.

Let’s suppose this taxpayer desires to defer the entire gain.  He or she, therefore, spends the entire sum of $1 million on a new commercial building within the allotted time window. In this scenario, the taxpayer receive non-recognition of the gain deriving from the converted property.  That’s because all of the funds are spent on the other similar property. In practice, the taxpayer has conducted an “exchange” of property and is able to defer his or her tax liability from the conversion. 

New York City Tax Attorneys To Assist

Here at Mackay, Caswell & Callahan, P.C., we make an effort to simplify these types of complex topics. Section 1033 can be a bit tricky, but much of it makes intuitive sense.  It’s basically geared toward making sure that owners have access to adequate relief in the event of an involuntary conversion. Section 1033 also has its own rules pertaining to basis transfer, replacement property from related persons, and other topics. Again, in the future we’ll try to come back to these topics, but the above description should serve as a decent introduction. If you need further information related to Section 1033, or if you have a question related to back tax debt, OICs or another tax matter, don’t hesitate to call.  One of our top New York City tax attorneys will get started on your case right away! 

Image credit: Nicci Romanovsky 

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