 Hello and welcome to the session in which we will discuss the concept of involuntary conversions section 1033 We have to put this concept in a context and this context is non-taxable gains So involuntary conversion is part of a series of transaction Where the gain that you realize may not be taxable now. It will be deferred What does that mean if we remember the basic formula for computing the realized gain which is a mount realized Minus T adjusted basis would either give us a realized gain or a realized loss That's assuming we are dealing with a gain. So we sold something for a hundred thousand the cost basis was sixty thousand Therefore, we have a gain of forty thousand now. Maybe this gain might be the third If it's the third then nothing will be recognized or this gain Might be none of it is the third and all of it is recognized means all of it is taxable So involuntary conversions fall into this category So notice we in the prior session we looked at qualified like kind exchanges section 1031 in this session we would look at involuntary conversion and as I am preparing this recording hurricane Ian is hitting Florida and this picture is from Florida actually and if you notice It's an involuntary conversion people the owner of these These apartment building they did not want this to happen the owners of these boat. They don't want this to happen So they lost their asset in voluntary and this is what we mean by involuntary Conversion so a taxpayer may sell a property exchange it or dispose of it But in an involuntary conversion again, what could be an example of involuntary conversion? Well destruction theft seizures Requisition condemnation sale or exchange under the threat of condemnation of property and we're gonna talk about condemnation of property simply put The the taxpayer did not choose this Something was forced on that taxpayer However, if a voluntary act made by the taxpayer, that's not involuntary conversion For example, if you destroy your own property Or if you, you know, put your property on fire, that's not gonna be considered involuntary conversion before we proceed any further I have a public announcement about my company farhat lectures comm Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics My resources consist of lectures, multiple choice questions, true-false questions as well as exercises Go ahead start your free trial today. No obligation. No credit card required We have to understand that section 1031 applies to gain realized from involuntary conversion Not for losses and we'll talk about this later Now also you need to understand in contrast to section 1031, which is like kind exchange treatment The tax treatment of gains from involuntary conversion is not limited to real property So if we go back to this picture Real property is the building is the apartment building. This is real property Personal property is the boat or not sure if you see a vehicle here or not. I'm not really sure but Section 1033 applies to real and personal property as well Let's take a look at the gain rules So an involuntary conversion the taxpayer usually would receive some sort of an insurance proceeds So maybe the owner of the boat would receive some insurance proceed or a condemnation award if the government takes over Your asset they want to open a highway. They want to maybe build a public park They want to build an airport and they want your land they force you to sell it They're gonna give you something or some other at some other form of compensation that aim to restore The original owner him or her to the position held right before the conversion if the taxpayer receives replacement property or receive money and Convert them into a replacement property with an specified period of time He or she should not include any gain or loss So what do you have to do if you receive the money and let's assume you receive the money and you happen to have a realized gain Well realized gain could be recognized. Well, if you want to avoid the recognition Reinvest the money with an specified period of time, which we'll talk about So the gain will be deferred an Exception applies when the taxpayer does not reinvest the entire amount realized If it means if you get the money and if you don't reinvest it if you don't take this money and buy the property Trying to replace then guess what the amount that's not invested Will be taxable will be recognized gain Okay, and the basis you need to know what the basis period the basis and the holding period of the replacement property Are the same as they converted so they will start with the original property because you had no choice now bear in mind If the property is converted to money simply put you get the money and you're not going to do anything with it They simply put your boat was destroyed. You did not replace it Well, or you replace it with some dissimilar property that taxpayer would recognize a gain From the amount realized and the adjusted basis simply put it's as if it's sold Because you did not the rules are if you wanted to reinvest The money in similar property to put you back in the original position then that's fine The government says yes, we're willing to give you a break Otherwise if you're gonna keep the money, it's as if you sold it The basis of this similar property is determined by the cost of acquisition simply put you are buying a new property brand new different now The best is to look at an example Ralph owned the van that he used to support people moving from one area to the other The van operated for five years before it was completely destroyed by a fire That Ralph has nothing to do with the fire involuntary just to mention this at the time of the fire The van has an adjusted basis of 25 and a fair value of 26,200 That's not really kind of realistic in the real world because after you use a van The fair value of it will be well should be lower But you know just for the sake of illustration now Ralph filed insurance claim and received 29,000 it must be worth it an insurance proceeds two month after the fire So here's what's gonna happen first first We have to determine the amount realized well the amount realized is what you received from the insurance company 29,000 minus the adjusted basis which will give us a Realized gain by Ralph of 4,000 now we need to determine how much of that amount is actually recognized recognized means taxable Assume now that five months later after Ralph has received the insurance He purchased a new van for 28,000 and resumed his work. Basically. He's back to where he was originally Determined the amount of gain to be recognized by Ralph from the conversion of his old van in the basis of the newly acquired van Well, here's what's gonna happen They gave him 29,000 He only invested 28. Well, guess what the amount that he did not invest He kept he kept in his bank account now Ralph has the ability to pay taxes on this gain of 1,000 so if we want to look at it this way the gain was 4,000 of which three is deferred or not taxable and 1,000 is Taxable 1,000 is taxable now the new basis for the van is computed as follow The acquisition cost of the new van, which is the 28,000 minus to the third gain so that the third gain Reduced your basis so you would recapture this gain down the road Assume now that Ralph use the insurance proceeds to acquire a second hand van for 26 and To reimburse a loan he owns to the bank for 3,000. That's what he did with the money now Well determine the amount of gain to be recognized because we already computed the amount realized in this Case Ralph would recognize a gain of 3,000 which is the amount of insurance proceeds Collected and not invested in the replacement property. You did not reinvest this you just basically paid off the loan Ralph's basis in the new property equal to the amount reinvested which is 26,000 minus the deferred gain here the deferred gain is a thousand remember we said the The the gain was for he invested he paid the bank pay 3,000 to the bank and 1,000 was actually deferred because it was invested in the van Therefore 26 minus the the third portion the the third portion will give us a basis of 25,000 now, let's talk about loss rules. We have to keep in mind that section 1031 Now, let's talk about loss rules It's important to note that involuntary conversion does not apply to losses if the losses are realized They are recognized now bear in mind losses from personal use property are no neither recognized nor postponed So keep that in mind. We're still you are still dealing with business use or personal and real property example Ralph owned a van that he used to support people moving from one area to the other the van was operated for Five years was completely destroyed by the fire at the time of the fire The van had an adjusted basis of 25 a fair value of 26 200 now Ralph filed the claim and the insurance company only gave Ralph $8,000 now we have to complete the realized gain or loss, which is we have a loss here The loss is the difference between what he received from the insurance company 25 25 what he received from the insurance company 18,000 and the basis of 25 which is the loss is 7,000 now the entire loss is Recognized why because it's a loss involuntary conversion Don't ask you to the to defer the loss in contrast in contrast the section 1031 section 1031 You always have to defer the loss. Just I'm making this point Comparing and contrasting now. We have to learn about rules that deals with section 1031 specific rules requirements You might be asked about as mentioned to be eligible for non-recognition under section 1033 not 1031 The person should reinvest the insurance proceeds and the replacement property. That's given You have to reinvest if you keep the money it becomes taxable means now you have cash in the bank The IRS says well, guess what you have the ability to pay us. You should pay us In addition, the property should be acquired within a specified period, which we're gonna talk about What is the definition of a replacement property? A replacement property should be similar or related in service or or use to the involuntary Converted property now when it comes to section 1033 they are more restrictive than section 1031 if you remember in section 1031 I said I am not gonna go into the rules of section 1031 what's a qualified property? They will give you this but I can tell you this much They don't care if you replaced a warehouse with a building or a land with something else as long as that's real property They're very flexible when it comes to section 1033 It has to be similar or related in service So we're gonna see what we mean by this the definition of replacement property differ based on whether the owner of the property is an Owner investor or an owner user So you could be an owner of an asset a fleet of trucks you are the investor of that company That's that's one option or you can be the owner the owner user You can be the owner of that truck personally not the owner of the Rental property and using it yourself. Also, there are different rules for property condemnation So we're gonna go over the rules briefly just to know so if it's an owner invested There's something called use test an example of an owner invested would be a taxpayer who owned property and Rented to another party. So you own the truck, but you don't use the trucks you rent them to another property So you'll be basically the last sore you're the investor for an owner investor The replacement property must be used in similar endeavor In other words the taxpayer use test must be satisfied in similar endeavor There doesn't have to be the same but similar for example a taxpayer converting a rental apartment building Maybe replaced with another property that produces rental income. They're okay with this However, a rental property building cannot be replaced with a personal residency. You cannot say, okay, I lost my rental apartment building I want to Buy a house with that money. That's not acceptable, but you can buy another rental business That's okay. If you would invest your money in another rental business It doesn't have to be rental apartment building. This is owner investor Now if we look on the other hand owner user, which is it means there's a function functional use test here And owner user is a taxpayer who owns the property and use it in his or her own business or trade Like manufacturer who owns an income producing property under those circumstances. You are more restrictive Okay, so if you lost this asset you have to replace it with Not the exact but similar and use so the rule that applied to owner investor are more restrictive than those applicable to owners Owners investor in detail the replacement property must have the same not similar Sorry, I said similar the same use to the owner as the converted property So for example a manufacturing plant is not considered a replacement Property for a wholesale grocery warehouse so you cannot replace those you have to get a manufacturing plan You have to get back to your manufacturing plan Each property has a different function to the owner user because a manufacturing plant is totally different than a wholesale grocery warehouse You would say a grocery warehouse But if you are renting apartment building and now you're renting truck you're still in the rental business if you're owner investor Now property condemnation is when the government takes over your asset by force Through something we call eminent domain because they won't again Expand the highway Build an airport whatever the reason is it's when the government forces the taxpayer to give up the property In general the rules that apply to the replacement of condemnation property are more flexible They have to because now the government is forcing you to do something which is Most people they do fight this in the court, but if they eventually lost Well, at least the IRS should give them some flexibility in this So there are more flexible than those applicable to other involuntary converted property For example an improved real property may be replaced with an unimproved. It means it either is nothing on it Improved mean, you know, it's zoned. It's ready to be To be sold as separate unit. You can replace it with unimproved Real property the time period how long do you have the taxpayer generally will have normally will have two year period After the close of the taxable year in which the gain was realized to replace the converted property with another qualifying property This is for individual The time period is Extended to three years for condoned business property If that's the case three in four years for principal residents destroyed in federally declared Disaster area most likely from the hurricane en that's going to be a federally most likely federally Declared disaster area the replacement time period start from when the involuntary conversion or the threat of the condemnation occurred Let's take a look at an example to see how the time period work A taxpayer office building was destroyed by a fire on December 31st year x4 x3. Sorry So this is x3 And the building was destroyed the office building was destroyed on december toward the end of the year on april 10th x4 So simply put few months later in x4 Taxpayer received the insurance and decided to use the the entire amount to acquire a replacement building Now what is his or what is her? Replacement period well, guess what this is a business property. You still have the taxpayer would have still have up to x5 And x Six so three year after the close year. This is a business property. So notice. It's a very generous it's a very generous period for business property three years after the close year of What happened which is x3 now think about it if this happened at the beginning of x3 And you'd have one two three almost four years to do the replacement So it's very important to understand involuntary conversions. How do involuntary conversion work section 10 33 Again, we looked at section 10 31 section 10 33 We have other transactions such as the sale of taxpayer principal residents again all these transactions falls under the umbrella of It's either non-taxable or deferred. We're gonna see that the sale of tax taxpayer principal residents just simply it's non-taxable gain and we'll see the rules When we cover this when we cover this topic, what should you do now? Go to far hat lectures whether you are a cpa candidate ea candidate or an accounting student It's very important that you understand this topic. You don't take any chances on property transaction Whether an ea exam or cpa exam. I'm here to help Good luck study hard and stay safe