When the government takes your property through eminent domain, or a fire or storm destroys it, you didn’t choose to sell, but you can still owe tax on the gain. Section 1033 of the tax code lets you defer that gain by reinvesting in replacement property.
Most investors know the 1031 exchange. Far fewer know the 1033, and in several important ways it is more flexible. Here is how it works, how it compares with a 1031, and how NNN properties fit as replacement property.
Tax disclaimer: We are commercial real estate brokers, not CPAs, tax advisors or attorneys. This article is general information, not tax or legal advice. Involuntary conversion rules depend on your facts, so verify and confirm everything here with your CPA and attorney before you act.
What Counts as an Involuntary Conversion?
Section 1033 applies when your property is turned into cash or other property against your will. That includes:
- Condemnation (eminent domain): a government or authority takes your property for a road, school, utility or other public use and pays you an award.
- Sale under threat of condemnation: you sell before the taking happens because you have reasonable grounds to believe the property will be condemned if you don’t.
- Destruction: a fire, hurricane or other casualty destroys the property and you receive insurance proceeds.
- Theft or seizure.
1031 vs. 1033 at a Glance
| 1031 Exchange | 1033 Exchange | |
|---|---|---|
| What starts it | A sale you choose to make | Condemnation, threat of condemnation, casualty or theft |
| Qualified intermediary | Required | Not required |
| Can you receive the cash? | No | Yes |
| Identification deadline | 45 days | None |
| Time to buy replacement | 180 days | Generally 3 years for condemned business or investment real estate; 2 years for other conversions |
| What you can buy | Like-kind real estate | Like-kind real estate for condemned business or investment real estate; “similar or related in use” for most other conversions |
| Can you replace equity with debt? | No. Cash you keep is taxable | Yes. The test is the cost of the replacement property |
| If you reinvest only part | Cash and debt relief not replaced are taxable | Tax only on the amount you don’t reinvest |
The Big Advantage: You Can Replace Equity With Debt
This is the 1033 benefit most investors have never heard of. Under Section 1033, the question is whether the cost of your replacement property is at least as much as the amount you received. You don’t have to put the actual cash into the new property, and a loan counts toward the cost.
| Example: $2,000,000 Condemnation Award | 1031 Exchange | 1033 Exchange |
|---|---|---|
| Replacement property price | $2,000,000 | $2,000,000 |
| Your cash into the property | $2,000,000 (all of it) | $400,000 down |
| New loan (80% LTV) | None needed | $1,600,000 |
| Cash you can keep | $0 without paying tax on it | $1,600,000 |
| Gain deferred? | Yes, if all cash is reinvested | Yes, fully, because the property cost at least $2,000,000 |
In this example, the 1033 investor defers all of the gain and keeps $1.6 million of cash to use however they choose, including buying a second property. In a 1031 exchange, taking that cash out would be taxable.
One catch: the amount you have to match is the full amount realized, not just your equity. If part of the award went to pay off your mortgage, that payoff still counts. For example, if a $3 million award paid off a $1 million loan, you generally need to buy at least $3 million of replacement property to defer all of the gain.
The Deadlines
- Condemned business or investment real estate: generally 3 years after the end of the first tax year in which you realize any gain.
- Other involuntary conversions, such as a fire or casualty: generally 2 years after the end of the first tax year in which you realize any gain.
- The window can open as early as the threat of condemnation, so property bought after a credible threat can count.
- If you need more time, you can ask the IRS for an extension, but don’t count on getting one.
There is no 45-day identification rule, which gives you time to find the right property instead of rushing.
What You Can Buy
If your condemned property was business or investment real estate, you can use the same broad “like-kind” standard as a 1031 exchange. That means you can replace it with almost any investment real estate, including a NNN property.
For most other conversions, such as a rental building destroyed by fire, the replacement generally must be “similar or related in service or use.” For investors who lease out property, the IRS looks at whether your role and risks as an owner are similar, so replacing one rental property with another is often acceptable. Confirm your specific case with your CPA.
Your Options With a $1,000,000 Award
Because the test is the cost of the replacement property, you can choose how much of the award to reinvest as cash and how much to finance. Here are four ways to handle a $1,000,000 condemnation award, assuming it is all gain and a combined tax rate of about 35%:
| Pay the Tax | All Cash (NNN or DST) | 50% Loan (NNN Property) | Zero Cash Flow DST (80% LTV) | |
|---|---|---|---|---|
| Tax due now | About $350,000 | $0 | $0 | $0 |
| Your cash into the replacement | None | $1,000,000 | $500,000 | $200,000 |
| Loan | None | None | $500,000 | $800,000 |
| Replacement property cost | None | $1,000,000 | $1,000,000 | $1,000,000 |
| Cash left in your pocket | About $650,000 | $0 | $500,000 | $800,000 |
| Income from the property | None | Full rent, no loan payments | Rent minus loan payments | Little or none; rent pays down the loan |
All three replacement options defer the entire gain. The difference is the balance between cash in your pocket and income from the property:
- All cash: buy a NNN property or DST with no debt. You keep no cash, but you get the most income and the least risk.
- 50% loan: buy a $1,000,000 NNN property with $500,000 down and a $500,000 loan. You keep half the award in cash and still collect rent after the loan payments.
- Zero cash flow DST: keep the most cash. A zero cash flow DST (Delaware Statutory Trust) is a highly leveraged DST, often around 80% loan-to-value, where the tenant’s rent goes to paying the loan instead of paying distributions. You put in $200,000, your share of the DST’s loan covers the rest, and you keep $800,000, about $150,000 more than if you paid the tax, while the rent pays down the loan and builds equity in the background.
Know the trade-offs: More leverage means more risk, since the property has to cover its loan payments. Zero cash flow DSTs in particular pay little or no income, carry high leverage, are illiquid and are generally limited to accredited investors. Because the rent pays down the loan, you may owe tax on income you don’t receive in cash (often called phantom income). DST interests qualify as like-kind real estate for condemned business or investment property, but confirm your situation with your CPA. Learn more on our DST Investments page.
Why NNN Properties Fit a 1033 Exchange
- Passive income: a good fit for owners who didn’t plan to sell and don’t want a new management job.
- Easy to finance: national-tenant NNN properties are popular with lenders, which helps if you use the equity-for-debt strategy.
- Flexible sizing: you can buy one larger property or several smaller ones to reach the amount you need to reinvest.
- Time to choose well: with up to 3 years, you can compare corporate ground leases, land & building deals and different tenants. See our NNN Tenant Profiles and Ground Lease vs. Land & Building.
Other Rules to Know
- Partial reinvestment: if you spend less than the amount realized on replacement property, you generally pay tax only on the part you didn’t reinvest.
- Related parties: C corporations, many partnerships and investors with more than $100,000 of gain from involuntary conversions in the year generally can’t buy the replacement property from a related person.
- Basis carries over: your new property’s tax basis is its cost minus the gain you deferred, so the tax is deferred, not forgiven.
- Reporting: you elect to defer the gain on your tax return, and you’ll need to report the replacement purchase. Keep good records of the award, the dates and what you buy.
If you are selling voluntarily instead, see our 1031 Exchange guide and 1031 deadlines.
Common Questions
What is a 1033 exchange?
A 1033 exchange lets you defer the tax on a gain when your property is involuntarily converted, for example taken by eminent domain, sold under threat of condemnation, or destroyed by fire or storm, as long as you buy qualifying replacement property within the time allowed.
Can I replace equity with debt in a 1033 exchange?
Generally, yes. Section 1033 looks at whether the cost of your replacement property is at least the amount you realized. A loan counts toward that cost, so you can buy a $2 million property with $400,000 down and still defer the gain on a $2 million award. Confirm the details with your CPA.
How long do I have to replace property in a 1033 exchange?
For condemned business or investment real estate, generally 3 years after the end of the first tax year in which you realize any gain. For most other involuntary conversions, generally 2 years.
Do I need a qualified intermediary for a 1033 exchange?
No. Unlike a 1031 exchange, a 1033 exchange does not require a qualified intermediary, and you can receive the award or insurance money directly.
Can I buy a NNN property in a 1033 exchange?
Yes, in many cases. If your condemned property was business or investment real estate, you can replace it with like-kind real estate, which includes NNN properties.
Can I use a DST in a 1033 exchange?
Often, yes. If your condemned property was business or investment real estate, a DST interest can qualify as like-kind replacement property. Some investors use a highly leveraged, zero cash flow DST so that their share of the DST’s loan covers most of the replacement cost, letting them defer the gain while keeping more of the award in cash. These DSTs have real trade-offs, including little or no income and possible phantom income, so review them with your CPA.
Does a sale under threat of condemnation qualify?
It can. If you have reasonable grounds to believe your property will be condemned if you don’t sell, a sale to the condemning authority or another buyer can qualify as an involuntary conversion.
What if I don’t reinvest all of the money?
You generally pay tax only on the part of the amount realized that you don’t spend on replacement property.
If your property is being taken or was destroyed, contact us. We have represented buyers on 225+ NNN transactions, and we can help you find replacement property that fits your timeline. Our buyer representation is always free to you.