1033 Exchange Replacement Property: Like-Use, Timing, and Basis

Replacement property in a 1033 exchange generally has to be “similar or related in service or use” to the property you lost, but the rule bends in several directions depending on what was converted and how. These 1033 exchange replacement property rules let you defer capital gains tax on insurance proceeds or condemnation awards that exceed your basis, as long as you reinvest in qualifying property within the deadline the statute gives you.¹ Pick the wrong replacement, or miss the window, and the full gain becomes taxable right away.

What Counts as “Similar or Related in Service or Use”

The IRS applies one of two tests, and which one you get depends on how you used the original property.²

If You Used the Property Yourself: The Functional Use Test

If you personally operated the property in your business, the replacement has to function the same way the original did. Physical characteristics and day-to-day use both matter. A business that loses a dry-cleaning plant needs another dry-cleaning operation, not a rental apartment complex or raw land held for later development.²

If You Leased It Out: The Relationship Test

If you held the property as an investment and leased it to tenants, the IRS looks at your relationship to the property rather than the tenants’ use of it. The management effort you put in, the risks you carried, and the kind of income you earned are what count. An investor who loses a residential apartment building can replace it with a commercial office building and still qualify, because the landlord role stays broadly the same.²

Either way, the replacement has to reflect the same kind of economic interest you lost. Swapping destroyed business inventory for a piece of equipment fails because the nature of the asset itself has changed.

When the Rules Loosen

Condemned Real Estate

When business or investment real property is taken by condemnation, the stricter “similar or related in service or use” standard is replaced by the broader like-kind test.³ Like-kind asks only whether both properties are real property held for business or investment. The specific use doesn’t need to match. A condemned office building can be replaced with undeveloped investment land; a condemned factory can be replaced with a rental apartment building. The looser standard doesn’t reach property held primarily for sale, such as a developer’s lot inventory.

Property Lost in a Federally Declared Disaster

If your business or investment property is destroyed in a federally declared disaster, any tangible property you acquire for use in any business qualifies as similar or related in service or use.² The replacement doesn’t even have to sit inside the disaster area.

Principal residences get their own treatment. Insurance proceeds for unscheduled personal property (the everyday household items not individually listed on your policy) are completely tax-free, with no obligation to replace them. The rest of the payout, covering the home and any scheduled contents, is treated as a single conversion, so you can pool it and reinvest in a replacement home without tracking item by item.¹

Destruction of a principal residence is also treated as a sale for Section 121 purposes, letting you exclude up to $250,000 of gain ($500,000 for joint filers) before Section 1033 is in the picture. When you calculate what you need to reinvest, the amount realized is reduced by whatever Section 121 already excluded.⁴ For many homeowners the exclusion wipes out the gain entirely and Section 1033 never has to be used.

Buying Stock Instead of Property Directly

You don’t have to buy replacement property outright. Section 1033 also lets you purchase a controlling interest in a corporation that owns qualifying replacement property. Controlling interest means at least 80 percent of the combined voting power of all voting stock and at least 80 percent of each other class of stock. The corporation’s property still has to satisfy the “similar or related in service or use” standard.¹

How Long You Have to Replace the Property

The window opens on the date of the conversion, or the earliest date you face a threat of condemnation, whichever comes first. It closes two years after the end of the first tax year in which you realize any part of the gain. Receive insurance proceeds and realize a gain in December 2025, and you have until December 31, 2027, to close on replacement property.¹

Three situations stretch that deadline:

Condemned business or investment real estate: three years.
A principal residence destroyed in a federally declared disaster: four years.¹
An IRS-granted extension, generally up to one additional year on a showing of reasonable cause.

Asking the IRS for More Time

If you can’t close in time, you can submit a written extension request explaining the delay, the steps you’ve taken to find a replacement, and the particulars of the original conversion: adjusted basis, dates, and proceeds received. File it before the replacement period ends when possible; the IRS will consider late requests if you explain the lateness. Construction that will not be finished in time counts as reasonable cause. High prices and a thin market do not.⁵

Buying From a Related Party

The restriction on buying replacement property from a related party is narrower than it is often described. It applies only to C corporations, partnerships in which C corporations own more than 50 percent of the capital or profits interest, and any other taxpayer whose total realized gain from involuntary conversions during the tax year exceeds $100,000.¹ If you fall into one of those categories, buying from a related party disqualifies the deferral unless the related party itself acquired the property from an unrelated person during the applicable replacement period. Individual taxpayers with realized gains of $100,000 or less are outside the restriction entirely.

Your Basis in the Replacement Property

The deferral works by burying the unrecognized gain inside the basis of the replacement, so the tax eventually surfaces when you sell. The formula: cost of the replacement property minus the deferred gain equals your new adjusted basis.

Say your converted property had an adjusted basis of $150,000 and produced $400,000 in proceeds, for a realized gain of $250,000. Buy a replacement for $500,000 and the full $250,000 is deferred; your basis in the new property is $250,000. Spend less than the amount realized and the shortfall is taxed right away. In the same scenario, a $350,000 replacement leaves $50,000 of recognized gain and $200,000 deferred, producing a basis of $150,000.⁶

Electing the Deferral on Your Return

Deferral is not automatic. You elect it by attaching a statement to your return for the year the gain is realized, describing the conversion, the date, the proceeds, and your intent to acquire replacement property.¹ The election is required even if you haven’t yet bought the replacement.

Casualties and thefts are reported on Form 4684. Involuntary conversions of business property also run through Form 4797, Sales of Business Property.⁷ Once you acquire the replacement, you confirm that the cost and timing requirements were met.

If the replacement period runs out without a qualifying purchase, or you end up spending less than the amount realized, file an amended return recognizing the deferred gain in the year of the original conversion. Individuals use Form 1040-X. File it as soon as you know the requirements won’t be met; waiting invites penalties and interest that run from the original due date.

1
Office of the Law Revision Counsel. 26 USC 1033 – Involuntary Conversions
2
Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts
3
eCFR. 26 CFR 1.1033(g)-1 – Condemnation of Real Property Held for Productive Use in Trade or Business or for Investment
4
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
5
Internal Revenue Service. Involuntary Conversion: Get More Time to Replace Property
6
eCFR. 26 CFR 1.1033(b)-1 – Basis of Property Acquired as a Result of an Involuntary Conversion
7
Internal Revenue Service. About Form 4797, Sales of Business Property