Non-Recognition Transactions — §1031, §1033, §121, Wash Sales

§1031 Like-Kind Exchange

Allows deferral of gain on exchange of business or investment property for similar property. Personal-use property does NOT qualify.

Key requirements:

• Both old and new property must be held for business/investment use
• Must be "like-kind" (real property for real property; personal property rules tightened after 2017)
• 45-day identification: Replacement property must be identified within 45 days of transfer
• 180-day closing: Must close on replacement property within 180 days (or return due date + extensions, if earlier)

Boot: Any non-like-kind property received (cash, debt relief) is taxable up to gain realized. Basis of replacement = basis of old + boot paid − boot received + gain recognized − loss recognized.

After 2017: Only real property qualifies. No more like-kind for personal property (equipment, vehicles, art).

Non-qualifying: personal-use real estate (main home, vacation home); US-situated property exchanged for foreign-situated property; inventory; real estate dealer's held-for-sale inventory.

Related-party §1031: Allowed between related parties, BUT if either party disposes of the property within 2 years of the exchange, the deferred gain/loss is recognized in the disposition year. Exceptions: death of a party, involuntary conversion, or proof the exchange + later disposition were not mainly for tax avoidance. File Form 8824. Related parties = close family + entities controlled >50%.

Basis of property received = adjusted basis of property given up + boot paid + gain recognized − boot received (FMV) − loss recognized.

§1033 Involuntary Conversion

Defer gain when property is destroyed, stolen, condemned (eminent domain), or disposed of under threat of condemnation. Insurance proceeds or condemnation awards may exceed basis → potential gain.

Replacement period:

• 2 years for most property (incl. personal residence) — measured from end of first tax year in which any part of gain is realized
• 3 years for business/investment real estate condemned (or under threat of condemnation) — eminent domain
• 4 years for livestock involuntarily converted due to weather-related conditions
• 4 years after the close of the first tax year in which gain is realized for a principal residence or its contents involuntarily converted in a federally declared disaster; IRS may grant an extension for reasonable cause

Gain deferred only to extent proceeds are reinvested in "similar or related in service or use" property. Any proceeds NOT reinvested = taxable gain.

Related party restriction: Unlike §1031, purchasing replacement property from a related party does NOT qualify for §1033 non-recognition.

Replacement property basis = basis of converted property at conversion date − recognized loss − proceeds not reinvested in similar property + recognized gain + additional cost of replacement.

Involuntary conversion of personal residence: Also qualifies for §121 exclusion if requirements met. Net gain after §121 exclusion can be deferred under §1033 if reinvested.

New: §1062 Qualified Farmland Sales (OBBBA, 2025)

New IRC §1062 (enacted by OBBBA) applies to sales/exchanges of qualified farmland property to qualified farmers in tax years beginning after July 4, 2025. Because most individuals use a Jan 1 calendar year, calendar-year individuals are generally first eligible in 2026.

Unlike installment sales (which defer the gain itself), §1062 requires the taxpayer to recognize the entire gain in the sale year, but may elect to pay the resulting net income tax in 4 equal annual installments. First installment due with the sale-year return (by unextended due date); remaining three due with each subsequent year's return. If an installment is not paid on time, the entire unpaid balance accelerates.

§121 Exclusion (Primary Residence Sale) — Quick Reference

Exclude up to $250,000 ($500,000 MFJ) of gain. Must own AND use as principal residence for ≥2 of last 5 years. Once every 2 years. [See full page: principal-residence-gain-exclusion-121.md]

Partial exclusion: Available for work change, health reasons, or unforeseeable events — prorated: (months owned ÷ 24) × $250,000 ($500,000 MFJ).

Special rule for surviving spouse: Can claim $500,000 if sale within 2 years of death, MFJ requirements met before death, and not remarried.

Wash Sale Rule (§1091)

If you sell a security at a loss and buy substantially identical security within 30 days BEFORE or AFTER the sale (61-day window), the loss is DISALLOWED.

Consequences:

• Disallowed loss added to basis of replacement shares
• Holding period of replacement includes old shares' holding period
• Applies to stocks, bonds, options — NOT to cryptocurrencies (IRS treats crypto as property, not securities)

Related parties: Losses on sales between related parties (family members, controlled entities) are also disallowed.

Installment Sales (§453)

Seller receives at least one payment after the tax year of sale. Gain recognized proportionally as payments received. Default method unless taxpayer elects out (reports all gain in sale year).

Formula: Gross profit % × payment received = gain recognized for that year.

Gross profit % = (Sale price − adjusted basis − selling expenses) ÷ (Contract price)

Interest must be charged: If < applicable federal rate (AFR), IRS will impute interest.

Depreciation recapture: Recaptured in year of sale, regardless of payments received.

Pledging rule: If installment obligation is pledged as collateral for loan, treated as payment received (to extent of loan proceeds).

Not eligible for installment method: publicly traded securities (stocks/bonds on an established market like NYSE/Nasdaq — must report gain in sale year even if payment received next year); inventory; property sold at a loss. (Private company stock sold to a private buyer IS eligible.)

Related-party installment sales: Allowed, BUT if the related-party buyer sells/disposes of the property within 2 years of the original sale, the original seller loses installment reporting and must report all remaining gain. Exceptions: involuntary conversion, death of original seller or buyer.

§1244 Small Business Stock

Loss on sale of §1244 stock treated as ordinary loss (not capital loss) up to $50,000 ($100,000 MFJ) per year. Excess = capital loss. Stock must be original issue from small business corporation (total capitalization ≤$1M); >50% of company income from active business operations; only original shareholders qualify (§1244 status does not transfer on resale).

Worthless Securities

Treated as sold on last day of tax year for $0. Result = capital loss. Must be completely worthless. 7-year amended-return window (vs. normal 3 years) to claim the loss. Report on Form 8949 with "WORTHLESS" in the applicable column and sale date = Dec 31 of the year it became worthless. Tokenized securities reported on Form 1099-DA (2025) rather than 1099-B, but loss treatment is similar.

Principal Residence Gain Exclusion (§121)

Rule

A taxpayer may exclude up to $250,000 ($500,000 for married filing jointly) of gain from the sale of a principal residence if the taxpayer owned and used the property as a principal residence for at least 2 of the 5 years preceding the sale. The exclusion can be used once every 2 years.

Ownership test: Taxpayer owned the home for ≥ 2 years during the 5-year period ending on the sale date. Use test: Taxpayer used the home as a principal residence for ≥ 2 years during the same period.

The 2 years need not be continuous — aggregate usage counts. "Principal residence" = where taxpayer lives most of the year; can be houseboat, mobile home, coop, condo — needs sleeping area, kitchen, bathroom.

Authority

• IRC §121(a) — $250,000 / $500,000 exclusion
• IRC §121(b)(1) — MFJ: both spouses must meet use test, at least one must meet ownership test, neither used exclusion in prior 2 years
• IRC §121(d) — Special rules for death of spouse, divorce, etc.
• IRC §121(c) — Partial exclusion for unforeseen circumstances (change in employment, health, unforeseen events)
• IRC §121(d)(9) — Military/government suspension of 5-year period
• Pub 523 — Selling Your Home

Edge Cases

• Partial exclusion (§121(c)): If taxpayer fails the 2-year test due to change in employment (new job ≥50 miles farther from old home than old job was), health reasons (doctor-advised move for taxpayer/spouse/child), or unforeseen circumstances (death, divorce, unemployment, multiple birth, disaster damage, involuntary conversion), a reduced exclusion applies. Formula: Reduced exclusion = full exclusion × (shorter of qualified-use period OR period since last exclusion, in days/months) ÷ 730 days (or 24 months).
• Widowed spouse: Surviving spouse can claim $500,000 MFJ exclusion if sale occurs within 2 years of spouse's death and MFJ requirements were met at death and not remarried.
• Unmarried co-owners: Two unmarried co-owners who both lived in and owned the home can each exclude $250,000 on separate returns ($500,000 total).
• Divorce transfer: Transfer incident to divorce is not a sale — no gain recognition. Recipient spouse inherits the transferor's basis and holding period BUT must independently meet the 2-year use test.
• Business use / home office: Depreciation taken after May 6, 1997 on the business portion is NOT excluded (recaptured on Form 4797). Non-qualified use periods (e.g., rental use after 2008) reduce the excludable portion pro-rata (non-qualified use time ÷ total ownership time).
• Land sale: Bare land (no home) sold alone cannot be excluded. But land adjacent to the main home, sold within 2 years before/after the home sale and part of the residence (not used for business), can be treated as part of the same sale and excluded.
• Military/government exception: Service members, Foreign Service officers, Peace Corps members, and intelligence community employees can suspend the 5-year test period for up to 10 years while on extended official duty. Helps satisfy the 2-year use/ownership requirement.
• Disability exception: If taxpayer becomes physically/mentally unable to self-care and owned the home ≥2 years and lived in it ≥1 year before becoming disabled, time in a licensed care facility (nursing home) counts as use — exclusion still available.

Common Traps

• QPRI basis reduction ambush: If a taxpayer excluded COD under QPRI, the basis in the home was reduced. Lower basis = higher gain on sale. If the taxpayer forgot about the QPRI exclusion, the sale may produce an unexpectedly large taxable gain — potentially exceeding the §121 exclusion.
• Multiple homes: Taxpayers with vacation homes sometimes try to rotate which is the "principal residence." IRS uses a facts-and-circumstances test — where you work, vote, register vehicles, spend time.
• MFS limitation: Each spouse gets only $250,000. If one spouse doesn't meet the use test, that spouse's half of the gain is taxable.
• Vacation/rental property is NOT a principal residence: Sale of a second home, rental, or raw land is fully taxable (no §121 exclusion).
• Prior §1034 rollover: For homes sold before 1997 under old rollover rules, the deferred gain from those transactions is embedded in the current basis — and may surface now, covered by §121 exclusion (which replaced §1034).

Connected Rules

• QPRI Exclusion §108(a)(1)(E) — QPRI basis reduction feeds directly into §121 gain calculation
• COD Attribute Reduction Ordering — QPRI reduces residence basis
• Capital Gains — Primary Residence — Holding period and rate classification
• Depreciation Recapture — Home office portion not covered by §121

Scenarios Worked

• Harold QPRI: If Harold sells the home in 2027 for a $50,000 gain, but his basis was reduced by $20,000 for QPRI in 2025, the actual gain = $50,000 + $20,000 = $70,000. If MFJ and meeting 2-of-5 test, §121 excludes up to $500,000 — so even with the basis adjustment, no taxable gain. But if single with $250,000 exclusion, the basis reduction still doesn't matter at this gain level.