What is an Involuntary Conversion?

1033 involuntary conversion

Section 1033 (a close cousin to 1031) allows you to defer the gain when you lose your property due to an involuntary conversion such as theft, condemnation, conversion, eminent domain takings, etc. The benefits of a 1033 are that you get to defer that gain. In some ways 1033 is better than 1031 because you have a longer period to reinvest your funds and you don’t need to use an intermediary to hold your funds.

The Downside

Here’s the downside of 1033. In order to do a 1033 you must have had an involuntary loss. Commonly this arises in the context of a condemnation proceeding started against you or knowledge of a credible threat of condemnation. The problem is that many municipalities are leery of starting an actual condemnation - they don’t want the litigation headaches. Instead they want to negotiate with the seller to come to an voluntary and mutually agreeable price. If you’re negotiating, it’s hard to say that you’re selling under threat of condemnation. So many people who are dealing with government bodies will set the transaction up under 1031 – and if it qualifies for 1031 great. As a backup they can have a 1033 to fall back on.

Saber Rattling Doesn’t Qualify

Mere saber rattling by the government authority (“well we could condemn if we wanted to…”) probably doesn’t qualify as a credible threat. So I advise people to do the 1031 or get something substantive from the government entity that they will condemn. For example if you can get them to put a representation and warranty in the purchase agreement that the government authority can and will condemn if this purchase agreement is not accepted then you’ve got something authoritative in writing that you can rely on for your 1033. Absent credible evidence that the governmental agency has the power to take the property and has in fact made an actual imminent threat to take the real property you’re better off structuring as a 1031.

Another consideration for owner-operators (owner-user), that run a business out of their condemned relinquished property is that the like-kind standard under 1033 may require them to purchase a replacement property that is “similar or related in service or use” to their old relinquished property.  This requirement under 1033 that the replacement property be functionally equivalent is a much more exacting standard than the broadly construed like-kind standard for real estate under 1031.  Rev. Rul. 64-237, 1964-2 C.B. 319, states that, with respect to an owner-user, property is not considered similar or related in service or use to the converted property unless the physical characteristics and end uses of the converted and replacement properties are closely similar.

  • 1031 Hotline: If you have questions about involuntary conversions, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

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