Comparing §1031 vs. §1033

After the last arti­cle on Post Hur­ri­cane Invest­ment Clean up there were sev­er­al ques­tions regard­ing the dif­fer­ences between §1031 and §1033.  Here is a com­par­i­son of both Sec­tions.

Novem­ber 1, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Com­par­ing 1031 and 1033 Exchanges

A 1031 exchange and a 1033 exchange are both tax-defer­ral strate­gies relat­ed to the relin­quish­ment of busi­ness or invest­ment real estate, and both are allowed under the Unit­ed States Inter­nal Rev­enue Code (IRC). How­ev­er, they each have unique appli­ca­tions that apply to dif­fer­ent sit­u­a­tions.

A 1031 Exchange:

When­ev­er you vol­un­tar­i­ly sell a busi­ness or invest­ment prop­er­ty, you gen­er­al­ly have to pay tax­es on any cap­i­tal gains real­ized at the time of sale. You will also have to pay tax­es on any depre­ci­a­tion deduc­tions you have tak­en over the life of the invest­ment. 

IRC Sec­tion 1031 allows you to post­pone pay­ing these tax­es if you rein­vest the pro­ceeds in sim­i­lar prop­er­ty as part of a qual­i­fy­ing “like-kind” exchange.

Per the IRS, replace­ment prop­er­ties are con­sid­ered “like-kind” if they are of the same nature or char­ac­ter, even if they dif­fer in grade or qual­i­ty. Real prop­er­ties gen­er­al­ly are of like-kind, regard­less of whether they are improved or unim­proved.

How Sec­tion 1031 defines “like-kind”

IRC Sec­tion 1031 states, “No gain or loss shall be rec­og­nized on the exchange of real prop­er­ty held for pro­duc­tive use in a trade or busi­ness or for invest­ment if such real prop­er­ty is exchanged sole­ly for real prop­er­ty of like-kind which is to be held either for pro­duc­tive use in a trade or busi­ness or for invest­ment.”

The IRS clar­i­fies the def­i­n­i­tion of like kind in more detail on its web­site:

Like-kind prop­er­ty is prop­er­ty of the same nature, char­ac­ter or class. Qual­i­ty or grade does not mat­ter. Most real estate will be like-kind to oth­er real estate. For exam­ple, real prop­er­ty that is improved with a res­i­den­tial rental house is like-kind to vacant land. One excep­tion for real estate is that prop­er­ty with­in the Unit­ed States is not like-kind to prop­er­ty out­side of the Unit­ed States.

The good news is that “most real estate will be like-kind to oth­er real estate.” This loose def­i­n­i­tion grants flex­i­bil­i­ty for exchang­ers: a §1031 exchange can be per­formed between many dif­fer­ent types of busi­ness or invest­ment prop­er­ty and still qual­i­fy. Sin­gle-fam­i­ly res­i­dences, mul­ti­fam­i­ly apart­ment build­ings, com­mer­cial office or retail space, farm­land, ware­hous­es, and oth­er prop­er­ties are con­sid­ered like-kind with each oth­er. You can per­form a §1031 exchange with mul­ti­ple prop­er­ties, a lease­hold with 30 or more years, a con­ser­va­tion ease­ment, or even an inter­est in a Delaware Statu­to­ry Trust (or mul­ti­ple DSTs). How­ev­er, there are impor­tant excep­tions and details that must not be over­looked.

The replace­ment prop­er­ties must also be held for “pro­duc­tive use,” mean­ing that they need to be held for busi­ness or invest­ment pur­pos­es. Addi­tion­al­ly, real prop­er­ty in the Unit­ed States is not like-kind to real prop­er­ty out­side the Unit­ed States.

Besides the need to pay atten­tion to what qual­i­fies as “like-kind,” there are spe­cif­ic rules and time­lines that must be fol­lowed in a 1031 exchange, includ­ing:

• Sell­ers must not ” con­struc­tive­ly receive ” sales pro­ceeds but direct those funds to a qual­i­fied inter­me­di­ary who can accom­mo­date the 1031 trans­ac­tion.
• Replace­ment prop­er­ty must be iden­ti­fied with­in 45 days.
• Replace­ment prop­er­ty must be pur­chased with­in 180 days.
• The exchang­or should be the same title hold­er and tax­pay­er.

1031 Equal and Up Rule:

• Replac­ing debt – The val­ue of debt on the replace­ment prop­er­ty must be greater than or equal to the amount of debt on the relin­quished prop­er­ty. Debt can be replaced by adding cash.
• Replac­ing equi­ty – The equi­ty in the replace­ment prop­er­ty must be greater than or equal to the amount of equi­ty in the relin­quished prop­er­ty. Equi­ty can­not be replaced by adding debt.

A 1033 Exchange:

When an own­er has an invol­un­tary sale or “con­ver­sion,” they may look to uti­lize a 1033 exchange. The 1033 exchange applies to sit­u­a­tions where prop­er­ty is destroyed, stolen, con­demned, or seized (emi­nent domain), and the own­er receives com­pen­sa­tion or insur­ance pro­ceeds as a result.

Just like sec­tion 1031, a 1033 exchange allows the tax­pay­er to defer the recog­ni­tion of any gain from an invol­un­tary con­ver­sion if they replace the relinquished/lost prop­er­ty with prop­er­ty that is “sub­stan­tial­ly sim­i­lar” or “relat­ed in ser­vice or use” to the prop­er­ty that was destroyed, stolen, seized, or con­demned.

“Sub­stan­tial­ly sim­i­lar” is not pre­cise­ly defined in the tax code but gen­er­al­ly means that the replace­ment prop­er­ty should be sim­i­lar in nature or func­tion to the prop­er­ty that was lost. It is a more rigid stan­dard than the more loose­ly defined “like-kind” stan­dard in sec­tion 1031.

Fur­ther, when it comes to a prop­er­ty that is “sub­stan­tial­ly sim­i­lar,” a dis­tinc­tion is made between an own­er-user and an own­er-investor.

For exam­ple, an own­er-user of a gro­cery store would like­ly have to replace an invol­un­tar­i­ly con­vert­ed prop­er­ty with anoth­er gro­cery store or some­thing “sub­stan­tial­ly sim­i­lar”. On the oth­er hand, an own­er-investor, whose rela­tion­ship to the busi­ness may be more pas­sive, may rely on the stan­dard that more close­ly resem­bles the like-kind stan­dard of sec­tion 1031. See also: Rul. 64–237, 1964–2 C.B. 319. 

There is an excep­tion relat­ed to the invol­un­tary con­ver­sion of real estate due to con­dem­na­tion. In a con­dem­na­tion sce­nario, the replace­ment prop­er­ty rules also resem­ble the like-kind rules found in a 1031 exchange.

Addi­tion­al rules and time­lines relat­ed to a 1033 exchange:

1. Instead of 45 and 180 days in as in a 1031, 1033 exchang­ers often have 2–4 years to com­plete their exchange.
   • Casu­al­ty or theft: The prop­er­ty must be replaced with­in a peri­od of two years after the end of the first tax­able year in which any part of the gain is real­ized.
   • Emi­nent domain: The prop­er­ty must be replaced with­in three years after the end of the first tax­able year in which any part of the gain is real­ized.
   • Declared dis­as­ter zone: if the tax­pay­er has lost prop­er­ty in a Pres­i­den­tial­ly declared dis­as­ter, the tax­pay­er receives a two-year exten­sion on the replace­ment peri­od, a total of four (4) years in which to replace the lost prop­er­ty. (See IRC Sec­tion 1033(h)).
2. No need for a Qual­i­fied Inter­me­di­ary (QI).
3. Relin­quished prop­er­ty pro­ceeds can be oth­er­wise invest­ed until the replace­ment prop­er­ty is pur­chased.

1033 Equal and Up Rule:

• Replac­ing equity—The cost of the replace­ment prop­er­ty must be greater than or equal to the net pro­ceeds of the relin­quished prop­er­ty. Equi­ty can be replaced by adding debt.
• Replac­ing debt – The val­ue of debt on the replace­ment prop­er­ty must be greater than or equal to the debt on the relin­quished prop­er­ty. Debt can be replaced by adding cash.

Unlike a 1031 exchange, a 1033 exchange would allow an investor to increase the debt on the replace­ment prop­er­ty and cash out the dif­fer­ence.

Exam­ple:

• Relin­quished prop­er­ty net pro­ceeds: $2,000,000
• Out­stand­ing debt on relin­quished prop­er­ty: $0
• Replace­ment prop­er­ty loan-to-val­ue: 50%
• The tax­pay­er invests $1,000,000 of cash and finances the oth­er $1,000,000.
• Total replace­ment val­ue: $2,000,000.
• Cash to the investor: $1,000,000.
• Tax-defer­ral: 100%

While 1031 and 1033 exchanges pro­vide tax defer­ral ben­e­fits, they are used in dif­fer­ent sit­u­a­tions. A 1031 exchange is for vol­un­tary exchanges of sim­i­lar prop­er­ties to defer cap­i­tal gains tax. In con­trast, a 1033 exchange is for invol­un­tary con­ver­sions due to events like destruc­tion, theft, or con­dem­na­tion to defer tax on the replace­ment prop­er­ty.

Investor Dis­clo­sure:

DST’s (Delaware Statu­to­ry Trusts) are for accred­it­ed investors only.  Please us for addi­tion­al details on how a DST may be a solu­tion to your §1031 and §1033 Exchange and com­pli­ment your finan­cial objec­tives. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

DST News would like to acknowl­edge the con­tri­bu­tion of con­tent by Four Springs Cap­i­tal, Madi­son Cap­i­tal Group and Cap­i­tal Square to the arti­cle.  These com­pa­nies are Delaware Statu­to­ry Trust (DSTs) spon­sors that pro­vide replace­ment solu­tions for finan­cial advi­sors to con­sid­er for §1031 and §1033 exchanges.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, in any form, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.