The Section 1033 election defers the gain on condemned real property when the proceeds are reinvested in qualifying replacement property. It does not defer Section 1245 recapture on equipment and other personal property, which is owed as ordinary income in the year the award is received. The order of operations therefore matters: calculate the recapture first, reserve cash for it, and structure the election around what is left. None of this is the eminent domain attorney’s job; it belongs to the owner’s tax professionals, with our help where it is wanted, and the goal is to make these determinations early enough that receiving the deposit does not start the Section 1033 deadlines before anyone has planned for them. Here is the sequence.
The short version. Work out the tax that cannot be deferred first and set that cash aside. Then plan the replacement purchase around what is left, and make the election on the return for the year the money is first received.
The two-step framework
Step one: calculate the Section 1245 recapture on the personal property components of the award. That number is fixed and cannot be deferred. The owner must keep enough cash to pay it. The calculation is set out in our article on Section 1245 recapture in a condemnation.
Step two: calculate the remaining gain on the real property, meaning the unrecaptured Section 1250 gain and any additional Section 1231 gain. That is the amount the Section 1033 election can defer. The owner’s capital available for reinvestment is the total award less the Section 1245 tax reserve.
Section 1250 recapture: the deferrable piece
Section 1250 applies to depreciated real property: buildings, structural improvements, and other improvements to real estate that have been depreciated. For commercial property held over time, the accumulated depreciation produces unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25 percent, separate from and in addition to the capital gain on appreciation above original cost.
Unlike Section 1245 recapture, unrecaptured Section 1250 gain may be deferred under Section 1033 if the owner makes a timely election and acquires qualifying replacement property within the replacement period. The gain is not eliminated; it carries into the basis of the replacement property. Deferral gives the owner the use of those funds in the meantime.
Making the Section 1033 election
The Section 1033 election is made on the return for the year in which gain is first realized. It defers recognition of gain to the extent the proceeds are reinvested in qualifying replacement property. For condemned real property held for business or investment, Section 1033(g) sets the replacement period at three years from the end of the first taxable year in which any part of the gain is realized. The 1033 exchange rules, the replacement period and what qualifies as replacement property are covered in full on our 1033 Exchange page.
When an award covers more than one kind of property
When a single condemnation involves both real property and personal property, the owner’s tax advisors will need to work out how the award is characterized for purposes of the election. Our approach is consistent: less is best in the formal documents. Unless the litigation or the settlement requires a particular breakdown, keep the settlement clean and let the CPA and tax professionals do the analysis with the most flexibility possible.
The pre-closing planning sequence (completed by the owner’s tax representative)
- Identify the Section 1245 assets in the taking and calculate the recapture on each.
- Reserve cash for the Section 1245 tax; it is owed regardless of reinvestment.
- Determine the net proceeds available for reinvestment after the Section 1245 reserve.
- Calculate the unrecaptured Section 1250 gain, the deferrable piece.
- Identify qualifying replacement property under Section 1033(g).
- Confirm the three-year replacement period for condemned business or investment real estate.
- Make the Section 1033 election on a timely filed return.
The deposit can start the clock
The replacement period is measured from the end of the first taxable year in which any part of the gain is realized. That is not always the year the final award is paid. When a condemning authority deposits its estimated compensation and the owner receives an amount above the property’s adjusted basis, gain is realized in that year, and the clock runs from the end of it. This is why the basis calculation belongs before the deposit is negotiated, and why the owner’s tax team, not the attorney, should have it in hand when the deposit is discussed.
The replacement period and buying early
One real advantage of Section 1033 over Section 1031 is that replacement property may be acquired before the condemnation proceeds are received, provided the purchase comes after the threat of condemnation was first communicated. This advance-purchase rule lets an owner who finds the right replacement property early lock it in without waiting for closing.
The bottom line
The Section 1033 election is not a magic eraser for the whole tax consequence of a condemnation. It is a deferral mechanism for the real property gain, and it takes planning, documentation and timely execution. Section 1245 recapture sits outside the election entirely and has to be planned for on its own.
Where a tax specialist fits
We are not the owner’s attorney and we do not negotiate awards. We run the recapture calculation, work the seven steps above with the owner’s CPA, and give the attorney the tax picture before the deposit and the settlement terms are final. If the owner does not need us, we say so. The first call is free.
Frequently asked questions
How is the Section 1033 election made? On a timely filed return for the year the gain is first realized, with a statement describing the involuntary conversion, the replacement property (or the intent to replace) and the computation of gain. The owner’s CPA prepares it; our page for CPAs and attorneys lists what they will need.
What is the replacement period for condemned real estate? Three years after the close of the first taxable year in which any part of the gain is realized, under Section 1033(g), for real property held for business or investment. Two years for most other property.
Can replacement property be bought before the award is paid? Yes, if the purchase comes after the threat or imminence of condemnation was first communicated to the owner. That is an advantage Section 1033 has over Section 1031.
Sequencing a specific award? A free thirty-minute call with Steve Medendorp walks through the reserve, the election and the replacement period before the proceeds arrive.
