What Is a 1033 Exchange? Deadlines, Replacement Property, and Election

A 1033 exchange lets you defer capital gains tax when property is destroyed, stolen, or condemned, provided you reinvest the proceeds into similar property within a set deadline. It’s not a tax eraser. Your original basis carries over into the replacement property, so the gain remains taxable if and when you later sell without reinvesting again. What the deferral does buy you is time and cash flow: you don’t have to write a check to the IRS at the same moment you’re trying to rebuild after a fire or replace land taken for a highway project.¹

The mechanism sits in Section 1033 of the Internal Revenue Code and applies only when you lose property involuntarily. Voluntary sales don’t qualify. This makes a 1033 exchange fundamentally different from a 1031 like-kind exchange, though the two share a family resemblance.

What Losses Qualify

Three categories of loss trigger 1033 treatment: destruction or theft, government condemnation, and the credible threat of condemnation.¹

The casualty and theft category is broad. Fires, hurricanes, floods, tornadoes, earthquakes, vandalism, and similar events all fit. When insurance pays out after one of these losses, the payment is your amount realized. If it exceeds your adjusted basis in the destroyed property, the excess is a gain, and that gain is what Section 1033 lets you defer.

Condemnation covers the exercise of eminent domain: a government body takes your private property for public use and pays you compensation. The threat of condemnation also qualifies, but only when a government entity has officially communicated its intent to acquire your property. An official resolution authorizing the acquisition typically clears that bar. Casual negotiations without a formal threat don’t.

How Long You Have to Reinvest

The replacement period opens on the earlier of two dates: when the property is actually disposed of, or when a threat of condemnation begins. The closing date depends on what happened to the property.¹

Casualty or theft: two years after the close of the first tax year in which you realize any part of the gain. A calendar-year taxpayer who realizes gain in 2025 has until December 31, 2027.
Condemned real property held for business or investment: three years after the close of that same first tax year. The 2025 example extends to December 31, 2028.
Principal residence in a federally declared disaster area: four years after the close of the first tax year in which gain is realized.²

One structural advantage over a 1031 exchange: you hold the proceeds yourself during the replacement period. There’s no qualified intermediary, and there’s no 45-day identification window to hit.

What Counts as Replacement Property

Which test your replacement property has to pass depends on how you lost the original.

The Functional Similarity Test

For casualty and theft losses, the replacement must be “similar or related in service or use” to what you lost.¹ It’s a demanding standard. A rental apartment building can be replaced with another rental apartment building. Swapping it for a retail shopping center probably fails, because the end use and physical characteristics are too different. For owner-users, the question is whether the new property serves the same practical function as the old one.

The Like-Kind Test for Condemned Real Estate

Real property held for business or investment that is condemned, or taken under threat of condemnation, gets a friendlier standard. Section 1033(g) lets you use the broader “like-kind” test instead of strict functional similarity. That means you can replace one type of business or investment real estate with another. An office building for farmland works. A warehouse for an apartment complex works. Both properties simply need to be held for business use or investment.¹

Note the boundary. Like-kind flexibility is available only for condemned real property. Property lost to fire, flood, or theft stays under the stricter functional test even if it was held for investment. The flexibility follows how you lost the property, not what kind of property it was.

Calculating Deferred Gain and New Basis

The rule underneath the rule: you owe tax only on the amount of proceeds you don’t reinvest. Spend at least as much on the replacement property as you received from the conversion, and the entire gain defers. Spend less, and the shortfall is taxable now.

An example. Your building has an adjusted basis of $100,000. A fire destroys it and insurance pays $300,000. The realized gain is $200,000. Buy replacement property for $300,000 or more and the full $200,000 defers. Spend only $250,000 and the $50,000 gap between proceeds and reinvestment is recognized as taxable gain; the remaining $150,000 stays deferred.¹

The deferred gain rides in the basis of your replacement property. The formula is the cost of the replacement minus the deferred gain. In the full-deferral case, $300,000 minus $200,000 gives a new basis of $100,000, the old basis carried forward. In the partial-deferral case, $250,000 minus $150,000 also gives $100,000. Either way, when you eventually sell the replacement, that embedded gain comes due.

Watch out for insurance payouts that route partly through your mortgage lender. If your insurer sends $200,000 directly to the bank to pay off the mortgage and $100,000 to you, your total amount realized is still $300,000. You have to reinvest at least $300,000 to defer the full gain, regardless of where the money went first.

If the Property Was Your Home

Homeowners get a second tool stacked on top of Section 1033. Under Section 121, you can permanently exclude up to $250,000 of gain on the sale of your principal residence, or $500,000 for married couples filing jointly, if you lived there for at least two of the five years before the conversion. An involuntary conversion counts as a sale for this purpose.³

Section 121 applies first, then Section 1033 covers whatever gain is left. The “amount realized” for 1033 purposes is reduced by the gain Section 121 already excluded. Say a married couple’s home with a $200,000 basis is destroyed and insurance pays $800,000. The realized gain is $600,000. Section 121 permanently excludes $500,000 of that. For 1033 purposes, the couple needs to reinvest only enough to cover the remaining $100,000. Spending at least $300,000 on a new home (the $800,000 in proceeds minus the $500,000 exclusion) defers the entire remaining gain.³

Skipping the Section 121 exclusion means deferring gain you could have eliminated outright. It’s one of the most valuable and most missed pieces of an involuntary conversion involving a home.

Depreciation Recapture on Business Property

Section 1033 doesn’t shield every type of gain. If you claimed depreciation on the converted property, which is common with rental buildings and business equipment, the gain attributable to that depreciation can be recaptured as ordinary income under Sections 1245 or 1250, even inside a 1033 exchange.⁴

There’s a partial reprieve. Recapture is limited to the sum of the gain you actually recognize on the conversion (the uninvested portion) plus the fair market value of any replacement property that is not the same type of depreciable property as the original. Reinvest the full proceeds into the same depreciable type of property and recapture drops to whatever gain you recognized from underspending. Replace a depreciable building with raw land, though, and recapture applies to the land’s value, because land isn’t depreciable.

So the replacement property choice does more than satisfy the similarity test. It also drives how much depreciation recapture you face.

Related-Party Restrictions

You can’t always buy the replacement from a family member or an affiliated business. Section 1033(i) blocks the deferral when replacement property is purchased from a related person, defined broadly under Sections 267(b) and 707(b)(1) to include family members, entities you control, and related corporations or partnerships.⁵

The restriction reaches three groups: C corporations; partnerships in which C corporations hold more than 50% of the capital or profits interest; and any other taxpayer whose aggregate realized gain on involuntarily converted property during the tax year exceeds $100,000. If your total realized gain stays at or below $100,000 in the year, and you aren’t a C corporation or a C-corp-dominated partnership, the related-party rule doesn’t apply to you. There’s also an exception when the related party originally acquired the replacement property from an unrelated person during the applicable replacement period.

For partnerships and S corporations, the $100,000 threshold is tested at both the entity level and the individual partner or shareholder level. A partner whose share of the gain exceeds $100,000 is subject to the restriction even if other partners aren’t.

How to Make the Election

You elect Section 1033 treatment on your federal income tax return for the year you realize the gain. The reporting form is Form 4797, Sales of Business Property, which covers involuntary conversions and the associated gain calculations.⁶

If you’ve already bought the replacement property by the time you file, report both the conversion and the replacement on Form 4797, including the deferred gain calculation and the new basis. If you haven’t acquired replacement property yet, report the realized gain and attach a statement to the return electing deferral under Section 1033. The statement should describe the conversion, state the gain realized, and confirm your intent to acquire replacement property within the statutory period.⁷

When the replacement is later purchased, attach another statement to that year’s return with the details of the acquisition. If you timely filed your original return without electing, you can still elect by filing an amended return within six months of the original due date (excluding extensions), with “Filed pursuant to section 301.9100-2” written at the top.⁸

If the replacement period expires without a qualifying purchase, or you spent less than the full proceeds, file Form 1040-X to report the previously deferred gain as taxable income for the year of the original election. The reverse works too: if you reported the gain as taxable and later acquire qualifying replacement property within the deadline, use Form 1040-X to claim the deferral retroactively.

Keep permanent records: the date and circumstances of the conversion, the adjusted basis of the original property, all insurance or condemnation payments received, the cost and acquisition date of the replacement property, and any depreciation or amortization previously claimed.⁷

Asking for More Time

If you can’t replace the property before the deadline, you can request an extension from the IRS by showing reasonable cause, such as ongoing construction that won’t finish in time. High property prices or thin market inventory don’t qualify as reasonable cause.⁹

File the extension request before the replacement period ends. If you miss that window, send it as soon as possible afterward with an explanation for the delay. The request has to include legal descriptions of the converted property, its adjusted basis, dates and amounts of all payments received, a description of your efforts to find replacement property, and a copy of the tax return where you reported the deferred gain. It can be faxed to 877-477-9193 or mailed to the IRS at 985 Michigan Ave., Stop 16, Detroit, MI 48226, addressed to the SB/SE Field Examination Area Director for your state.⁹

1
Office of the Law Revision Counsel. 26 U.S.C. 1033 Involuntary Conversions
2
Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts
3
Office of the Law Revision Counsel. 26 U.S. Code 121 – Exclusion of Gain From Sale of Principal Residence
4
Office of the Law Revision Counsel. 26 U.S. Code 1245 – Gain From Dispositions of Certain Depreciable Property
5
Office of the Law Revision Counsel. 26 U.S. Code 1033 – Involuntary Conversions
6
Internal Revenue Service. About Form 4797, Sales of Business Property
7
Internal Revenue Service. Publication 544 (2025), Sales and Other Dispositions of Assets
8
Internal Revenue Service. Instructions for Form 4797 (2025)
9
Internal Revenue Service. Involuntary Conversion: Get More Time to Replace Property