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Simple English definitions for legal terms
replacement property
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A quick definition of replacement property:
Replacement property: When someone loses their property due to a natural disaster, theft, or other reasons, they can use insurance or condemnation money to buy a similar property. This is called replacement property. If the new property is worth more than the old one, the owner can delay paying taxes on the difference. There are two laws that allow this: IRC § 1031 and IRC § 1033. The first one has a time limit for finding a replacement property and the second one has a longer time limit but stricter rules about what counts as a similar property.
A more thorough explanation:
Replacement property refers to a property that an owner purchases to replace a property that they have lost due to natural disasters, theft, or condemnation. The owner can use insurance or condemnation proceeds to buy a similar property to the one they lost.
For example, if a homeowner's house is destroyed by a fire, they can use the insurance money to buy a new house that is similar to the one they lost. The new house is the replacement property.
When the replacement property has a higher value than the lost property, the owner can defer recognition of the gain for tax purposes. This means that they don't have to pay taxes on the gain until they sell the replacement property.
There are two sections of the Internal Revenue Code that allow owners to defer recognition of replacement property: IRC § 1031 and IRC § 1033.
IRC § 1031, also known as a 1031 exchange, allows the owner to defer the recognition of the gain if they do not benefit from the proceeds during the replacement period and if they identify and acquire the replacement property after a certain timeframe after the loss.
IRC § 1033 also allows the owner to defer recognition of replacement property. Compared with § 1031, § 1033 does not have an identification period and has a longer replacement period. However, the standard that the replacement property be similar to the original lost property is more restrictive.