January 7th, 2025 Los Angeles Wildfires – Gain Deferral Election on Disaster Events Under IRC § 1033
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This memorandum addresses the process and implications of electing Section 1033 of the Internal Revenue Code (IRC) to defer recognition of gain resulting from the involuntary conversion of property due to the recent fires. Section 1033 provides a mechanism for taxpayers to defer taxable gains if the proceeds are reinvested in qualified replacement property within specific timelines.  Note that California follows the IRS on this election.

 

Key Provisions of Section 1033

Involuntary Conversion:

Section 1033 applies when property is involuntarily converted due to destruction (e.g., fire), theft, or condemnation. In this case, the fire qualifies as a triggering event.

Gain Deferral: 

Taxable gain is recognized only to the extent that the proceeds from insurance or other reimbursements exceed the cost of replacement property.

Replacement Property Requirement:

The replacement property must:

  1. Be similar or related in service or use to the converted property.
  2. Be acquired within the statutory replacement period.

Replacement Period:

The general rule is that replacement property must be acquired within two years after the end of the taxable year in which the first dollar of conversion gain is realized. For primary residences in a federally declared disaster area, the replacement period is extended to four years, or another period specified by the IRS.  Investment property will have a 2-year replacement period.

Taxpayers can request an extension of time for reasonable cause, meaning that circumstances beyond their control have prevented them from acquiring the replacement property within the allowed timeframe. Granting an extension is up to the IRS’ discretion, and is generally limited to one additional year.

Election Process:

  1. The election to defer gain under Section 1033 is made simply by omitting a gain from the return for the year that gain is realized as a result of an involuntary conversion, although you should attach a statement to the return electing 1033 treatment as well.  This easy rule does not come without a cost. When electing section 1033 deferral (either by showing details on the return or by omitting them in a “deemed election”), all tax years in which the taxpayer realized a gain will remain open until three years after the individual or business notifies the IRS it has or has not replaced the property. Thus, a taxpayer making a section 1033 election has an indefinite statute of limitations.
  2. If you do not purchase qualifying replacement property within the required two- or four-year window, you must amend the gain-year return to report the gain. Most partnerships, unless they have elected out of the BBA centralized partnership audit regime, will have to file an administrative adjustment request (AAR) in lieu of an amended return.
  3. The taxpayer should include a statement describing the involuntary conversion, the replacement property, and the calculation of the deferred gain.

 

Steps for Electing Section 1033

Assess Gain:

Determine the gain realized from insurance or other reimbursements for the destroyed property. The gain equals the amount received, minus the adjusted basis of the property.

Identify Replacement Property:

Ensure the replacement property meets the similarity or related-use test. California permits the replacement property to be located outside the State. For example:

  1. Business property must be replaced with similar business property.
  2. Investment property must be replaced with property of a like-kind nature. This refers to investment property, not the product type, so you could replace industrial with multi-family, etc.
  3. A principal residence can be replaced with another principal residence, and you can also (if eligible) exclude up to $500,000 of realized gain through IRC section 121, and use section 1033.
  4. Note that to avoid gain you must acquire replacement property equal in value to the property lost. However, there is no requirement to have the same amount of debt, so you could go from 50% debt to 75% debt and keep more of the cash proceeds realized from insurance, if you choose.
  5. During the replacement period there is no identification requirement until you report it on your tax return and the insurance proceeds can be under your control and not be held by a third-party accommodator like in a section 1031 exchange.


Track Replacement Period:

  1. Document the timeline for acquiring replacement property to ensure compliance with the statutory deadlines.
  2. For federally declared disasters, confirm the extended replacement period.


Elect Deferral:

  1. File the election statement with your income tax return for the year the gain is realized.
  2. Include all supporting documentation, such as proof of destruction, insurance proceeds, and purchase details of replacement property.


Monitor Compliance:

 Maintain records to verify that the replacement property meets the criteria and that the reinvestment was timely.

 

Considerations

Partial Replacement:

If replacement property costs less than the proceeds received, the difference will be recognized as taxable gain.

This information presented is for illustrative and informational purposes only. Articles are copyright of the respective publication and not for distribution. FB+D by Cerity Partners is not responsible for and does not endorse content on third party sites.

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