Sec. 1033 can allow for flexible tax-free reinvestments.

• Author: Wong, Alan

Taxpayers that own trade or business real property that is involuntarily converted and would like to take advantage of the ability to own a similar investment in a faster growing state or even an emerging market without recognizing the gain from the conversion should consider Sec. 1033.

Sec. 1033(a) covers property that is "compulsorily or involuntarily converted" into similar property or money "as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof." Sec. 1033(a)(1) provides that a taxpayer can elect to defer the gain on the conversion of such property if the property is replaced by, or the proceeds are reinvested in, similar or related use property. The term "similar or related in service or use" is not defined in the Code or the regulations.

The IRS has at times applied a functional use test where the replaced property would have to have closely similar physical characteristics and uses to the converted property but need not be exactly the same. Over the years the IRS and the courts have expanded this definition. Maloof, 65 T.C. 263 (1975), summarized prior court precedents in stating that

it is clear that the reinvestment must be made in substantially similar business property. Ellis D. Wheeler, 58 T.C. 459,463 (1972). Stated differently, the statute requires a "reasonably similar continuation of the petitioner's prior commitment of capital and not a departure from it." Harvey J. Johnson, 43 T.C. 736,741 (1965). While it is not necessary to acquire property which duplicates exactly that which was converted (Loco Realty Co. v. Commissioner, 306 F.2d 207 (8th Cir. 1962), revg. 35 T.C. 1059 (1961)), the fortuitous circumstance of involuntary conversion does not permit a taxpayer to change the character of his investment without tax consequences (see Liant Record, Inc. v. Commissioner, 303 F.2d 326 (2d Cir. 1962), revg. 36 T.C. 224 (1961)). [Maloof, 65 T.C. at 269] The IRS and the courts over the years have provided many examples to guide the taxpayer in meeting the "similar use" criteria.

In order for the taxpayer to qualify for nonrecognition of gain under Sec. 1033(a) (2)(B)(i), the law requires that the replacement property be acquired within two years after the close of the first tax year in which the property was involuntarily converted, while Regs. Sec. 1.1033(a)-2(c)(2) prescribes the exact form and prescription of the taxpayer's election.

There are special...