Nontaxable Disposition of Assets

Introduction

Not every asset disposition triggers an immediate tax liability. The Internal Revenue Code provides several nonrecognition provisions that allow taxpayers to defer (and sometimes permanently exclude) gains on qualifying transactions. The TCP exam tests your ability to calculate realized gain, recognized gain, and deferred gain on like-kind exchanges (IRC §1031) and involuntary conversions (IRC §1033), determine the basis of replacement property, and evaluate whether a given transaction qualifies for nontaxable treatment or must be reported as a taxable sale.

This page covers the two principal nonrecognition provisions — like-kind exchanges and involuntary conversions — with detailed calculation examples, and then provides a framework for distinguishing taxable from nontaxable transactions when reviewing client documentation.

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Like-Kind Exchanges (IRC §1031)

Overview

A like-kind exchange allows a taxpayer to exchange qualifying real property held for productive use in a trade or business or for investment and defer recognition of gain (or loss) on the disposition. The theory is that the taxpayer has merely changed the form of their investment without cashing out — so taxation is deferred until a taxable disposition occurs.

Qualifying Property

After the Tax Cuts and Jobs Act (TCJA) of 2017, §1031 applies only to real property. Personal property exchanges (vehicles, equipment, artwork, collectibles, cryptocurrency) no longer qualify.

Qualifies for §1031	Does NOT Qualify
Improved real property (office building, warehouse)	Personal property (machinery, vehicles, furniture)
Unimproved real property (vacant land)	Inventory or stock in trade
Domestic real property exchanged for domestic real property	U.S. real property exchanged for foreign real property
Leasehold interest in real property (≥ 30 years remaining)	Securities, stocks, bonds, partnership interests
Rental residential property exchanged for commercial property	Property held primarily for sale (dealer property)

Exam Tip

The "like-kind" requirement for real property is very broad — any real property held for business or investment can be exchanged for any other real property held for business or investment. An office building can be exchanged for farmland, or a warehouse can be exchanged for a retail store. The key disqualifier is use: the property must be held for business or investment, not for personal use or as inventory.

Boot: Cash or Non-Like-Kind Property

A like-kind exchange rarely involves a perfectly equal swap. When one party adds cash or non-like-kind property to equalize values, the additional property is called boot.

Boot Type	Effect on Payer	Effect on Receiver
Cash boot	Increases basis of new property	Triggers gain recognition (up to realized gain)
Non-like-kind property boot (e.g., equipment, vehicle)	Increases basis of new property	Triggers gain recognition; basis of boot received = FMV
Mortgage relief (other party assumes your liability)	Treated as boot received	Treated as boot given
Mortgage assumed (you assume the other party's liability)	Treated as boot given	Treated as boot received

info

When both parties relieve and assume mortgages, the mortgage amounts are netted. Only the party with the net mortgage relief is treated as receiving boot.

Gain Recognition and Deferral Formulas

The following formulas are critical for exam calculations:

$$\text{Realized Gain} = \text{FMV of Property Received} + \text{Boot Received} - \text{Adjusted Basis of Property Given} - \text{Boot Given}$$ $$\text{Recognized Gain} = \min(\text{Boot Received},\ \text{Realized Gain})$$ $$\text{Deferred Gain} = \text{Realized Gain} - \text{Recognized Gain}$$

Losses are never recognized in a like-kind exchange — any realized loss is fully deferred.

Basis of New Property

$$\text{Basis of New Property} = \text{Adjusted Basis of Old Property} - \text{Boot Received} + \text{Boot Given} + \text{Gain Recognized}$$

An equivalent way to think about it:

$$\text{Basis of New Property} = \text{FMV of New Property} - \text{Deferred Gain}$$

Exam Tip

The second formula is a quick check: the basis of the new property should always equal its FMV minus any deferred gain. If your calculated basis does not produce this result, recheck your work.

Holding Period

The holding period of the relinquished property tacks onto the replacement property. If the taxpayer held the old property for 3 years before the exchange, the new property is treated as held for 3+ years from day one.

Boot property received (non-like-kind property) gets a new holding period starting on the date of the exchange, with a basis equal to its FMV.

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Example 1: Basic Like-Kind Exchange (No Boot)

Example: Bear Co. owns a warehouse (adjusted basis $200,000, FMV $350,000) used in its business. Bear Co. exchanges the warehouse directly for an office building (FMV $350,000) owned by Gies Co., also used in business.

Step	Calculation	Amount
FMV of office building received		$350,000
Adjusted basis of warehouse given		$200,000
Realized gain	$350,000 − $200,000	$150,000
Boot received		$0
Recognized gain	min($0, $150,000)	$0
Deferred gain	$150,000 − $0	$150,000
Basis of office building	$200,000 − $0 + $0 + $0	$200,000

Verification: Basis of new property ($200,000) = FMV ($350,000) − Deferred gain ($150,000) ✓

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Example 2: Like-Kind Exchange with Boot Received

Example: Jordan owns an apartment building (adjusted basis $300,000, FMV $500,000) held for investment. Jordan exchanges it with Alex for a commercial retail space (FMV $440,000) plus $60,000 cash.

Step	Calculation	Amount
FMV of retail space received		$440,000
Cash (boot) received		$60,000
Total amount realized	$440,000 + $60,000	$500,000
Adjusted basis of apartment building		$300,000
Realized gain	$500,000 − $300,000	$200,000
Recognized gain	min($60,000, $200,000)	$60,000
Deferred gain	$200,000 − $60,000	$140,000
Basis of retail space	$300,000 − $60,000 + $0 + $60,000	$300,000

Verification: Basis ($300,000) = FMV of retail space ($440,000) − Deferred gain ($140,000) ✓

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Example 3: Like-Kind Exchange with Mortgage Relief (Boot)

Example: MAS Inc. owns a factory building (adjusted basis $400,000, FMV $700,000, subject to a $150,000 mortgage). MAS Inc. exchanges the factory for a distribution center (FMV $550,000) owned by Dana. Dana assumes the $150,000 mortgage on the factory. No other boot is exchanged.

From MAS Inc.'s perspective, the mortgage assumed by Dana is boot received.

Step	Calculation	Amount
FMV of distribution center received		$550,000
Mortgage relief (boot received)		$150,000
Total amount realized	$550,000 + $150,000	$700,000
Adjusted basis of factory		$400,000
Realized gain	$700,000 − $400,000	$300,000
Recognized gain	min($150,000, $300,000)	$150,000
Deferred gain	$300,000 − $150,000	$150,000
Basis of distribution center	$400,000 − $150,000 + $0 + $150,000	$400,000

Verification: Basis ($400,000) = FMV ($550,000) − Deferred gain ($150,000) ✓

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Example 4: Like-Kind Exchange with Mortgages on Both Sides

Example: Sam owns a rental property (adjusted basis $250,000, FMV $600,000, subject to a $200,000 mortgage). Sam exchanges the rental property for Priya's office building (FMV $500,000, subject to a $100,000 mortgage). Each party assumes the other's mortgage.

Item	Sam Assumes	Sam is Relieved of
Mortgage	$100,000 (boot given)	$200,000 (boot received)
Net boot received		$100,000

Step	Calculation	Amount
FMV of office building received		$500,000
Net boot received (mortgage relief)	$200,000 − $100,000	$100,000
Total amount realized	$500,000 + $100,000	$600,000
Adjusted basis of rental property		$250,000
Realized gain	$600,000 − $250,000	$350,000
Recognized gain	min($100,000, $350,000)	$100,000
Deferred gain	$350,000 − $100,000	$250,000
Basis of office building	$250,000 − $100,000 + $0 + $100,000	$250,000

Verification: Basis ($250,000) = FMV ($500,000) − Deferred gain ($250,000) ✓

caution

When netting mortgages, only the party with the net mortgage relief recognizes boot. The party with the net mortgage assumed is treated as giving boot (which does not trigger gain recognition).

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Related Party Rules for §1031

If a like-kind exchange occurs between related parties (as defined under §267(b) — family members, controlled entities, etc.), both parties must hold the replacement property for at least 2 years after the exchange. If either party disposes of the property within the 2-year period, the original exchange is disqualified and the deferred gain becomes taxable in the year of the subsequent disposition.

Related Party Rule	Detail
Holding requirement	Both parties must hold replacement property for ≥ 2 years
Consequence of violation	Deferred gain is recognized in the year of the early disposition
Exceptions	Death of either party, involuntary conversion, or non-tax-avoidance transactions

Example: Derek exchanges investment land (basis $100,000, FMV $250,000) with his sister Jamie for her rental building (FMV $250,000). Fourteen months later, Jamie sells the rental building for $260,000. Because the disposition occurs within 2 years and the parties are related, Derek must recognize his $150,000 deferred gain in the year Jamie sells the property.

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Deferred (Starker) Exchanges

Most like-kind exchanges do not happen simultaneously. A deferred exchange (also called a Starker exchange) allows a taxpayer to sell the relinquished property first and acquire the replacement property later, using a qualified intermediary (QI) to hold the proceeds.

Deadline	Rule
45-day identification period	Taxpayer must identify potential replacement property(ies) in writing within 45 days of transferring the relinquished property
180-day exchange period	Taxpayer must receive the replacement property within 180 days of transferring the relinquished property or by the due date (with extensions) of the tax return for the year of transfer — whichever is earlier
Three-property rule	Taxpayer may identify up to 3 replacement properties regardless of value
200% rule	Alternatively, taxpayer may identify any number of properties as long as their aggregate FMV does not exceed 200% of the FMV of the relinquished property

warning

If the taxpayer has actual or constructive receipt of the exchange proceeds (e.g., the proceeds are deposited in the taxpayer's bank account rather than held by a QI), the exchange fails and the transaction is treated as a taxable sale. The qualified intermediary structure is essential.

Example: Illini Entertainment sells a commercial building (adjusted basis $500,000) for $900,000 on March 1. The proceeds are held by a qualified intermediary. On April 10 (within 45 days), Illini Entertainment identifies a replacement office complex. On July 15 (within 180 days), the QI uses the proceeds to acquire the office complex for $950,000, and Illini Entertainment pays $50,000 of additional cash.

Step	Calculation	Amount
FMV of office complex received		$950,000
Amount realized on old property		$900,000
Adjusted basis of old building		$500,000
Additional cash paid (boot given)		$50,000
Realized gain	$900,000 − $500,000	$400,000
Boot received		$0
Recognized gain	min($0, $400,000)	$0
Deferred gain	$400,000 − $0	$400,000
Basis of office complex	$500,000 − $0 + $50,000 + $0	$550,000

Verification: Basis ($550,000) = FMV ($950,000) − Deferred gain ($400,000) ✓

Because Illini Entertainment reinvested all of the proceeds (and more), no boot was received and the entire gain is deferred.

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Involuntary Conversions (IRC §1033)

Overview

An involuntary conversion occurs when property is destroyed, stolen, condemned, or disposed of under threat of condemnation, and the taxpayer receives insurance proceeds, a condemnation award, or other compensation. IRC §1033 allows the taxpayer to elect to defer the gain if the proceeds are reinvested in similar-use replacement property within the required replacement period.

Unlike §1031 (which is mandatory if the requirements are met), §1033 deferral is elective — the taxpayer must choose to apply nonrecognition treatment.

Qualifying Events

Qualifying Event	Description
Destruction	Fire, flood, storm, earthquake, or other casualty
Theft	Property stolen from the taxpayer
Condemnation	Government takes property through eminent domain
Threat of condemnation	Taxpayer sells property after being informed condemnation is imminent

Direct Conversion vs. Proceeds Received

Conversion Type	Rule
Direct conversion (property received directly as compensation)	No gain recognized — mandatory nonrecognition; basis of replacement property = basis of old property
Proceeds received (cash from insurance, condemnation award)	Gain recognized only to the extent the proceeds exceed the cost of replacement property; taxpayer must elect deferral

Replacement Property Requirements

Property Type	Replacement Standard	Replacement Period
Personal-use or business personal property	Similar or related in service or use (functional-use test — must serve same function)	2 years after close of the taxable year in which gain is first realized
Real property condemned (business/investment use)	Like-kind (broader — any real property held for business or investment)	3 years after close of the taxable year in which gain is first realized
Federally declared disaster (principal residence)	Tangible replacement property for scheduled personal property	4 years

info

The replacement standard for condemned real property is the broader like-kind standard (same as §1031), while other involuntary conversions use the narrower functional-use test. This distinction is frequently tested on the exam.

Gain Recognition and Deferral Formulas

$$\text{Realized Gain} = \text{Amount Realized (proceeds)} - \text{Adjusted Basis of Converted Property}$$ $$\text{Recognized Gain} = \max\bigl(\text{Proceeds} - \text{Cost of Replacement Property},\ 0\bigr)$$ $$\text{Deferred Gain} = \text{Realized Gain} - \text{Recognized Gain}$$

Basis of Replacement Property

$$\text{Basis of Replacement Property} = \text{Cost of Replacement Property} - \text{Deferred Gain}$$

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Example 5: Full Reinvestment — Complete Deferral

Example: Bear Co.'s warehouse (adjusted basis $300,000) is destroyed by a fire. Bear Co. receives $500,000 in insurance proceeds and uses all $500,000 to purchase a new warehouse within 2 years.

Step	Calculation	Amount
Insurance proceeds (amount realized)		$500,000
Adjusted basis of destroyed warehouse		$300,000
Realized gain	$500,000 − $300,000	$200,000
Cost of replacement warehouse		$500,000
Proceeds not reinvested	$500,000 − $500,000	$0
Recognized gain	max($0, $0)	$0
Deferred gain	$200,000 − $0	$200,000
Basis of new warehouse	$500,000 − $200,000	$300,000

Bear Co. defers the entire $200,000 gain. The basis of the new warehouse equals the basis of the old warehouse — the deferred gain is preserved in the lower basis.

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Example 6: Partial Reinvestment — Partial Recognition

Example: BIF Partners owns investment land (adjusted basis $150,000) that is condemned by the city for a highway project. BIF Partners receives a condemnation award of $400,000. BIF Partners elects §1033 treatment and purchases replacement investment land for $350,000 within 3 years (condemned real property held for investment — the 3-year replacement period applies).

Step	Calculation	Amount
Condemnation award (amount realized)		$400,000
Adjusted basis of condemned land		$150,000
Realized gain	$400,000 − $150,000	$250,000
Cost of replacement land		$350,000
Proceeds not reinvested	$400,000 − $350,000	$50,000
Recognized gain	max($50,000, $0)	$50,000
Deferred gain	$250,000 − $50,000	$200,000
Basis of replacement land	$350,000 − $200,000	$150,000

BIF Partners recognizes $50,000 of gain (the portion of the proceeds not reinvested) and defers $200,000.

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Example 7: Proceeds Exceed Cost — Full Recognition Scenario

Example: Alex owns a rental property (adjusted basis $180,000) destroyed by a storm. Alex receives $280,000 in insurance proceeds but only purchases replacement rental property for $170,000 within the replacement period.

Step	Calculation	Amount
Insurance proceeds (amount realized)		$280,000
Adjusted basis of destroyed property		$180,000
Realized gain	$280,000 − $180,000	$100,000
Cost of replacement property		$170,000
Proceeds not reinvested	$280,000 − $170,000	$110,000
Recognized gain	min($110,000, $100,000)	$100,000
Deferred gain	$100,000 − $100,000	$0
Basis of replacement property	$170,000 − $0	$170,000

Because the unreinvested proceeds ($110,000) exceed the realized gain ($100,000), the entire gain is recognized. No deferral is available — the basis of the replacement property is simply its cost.

caution

Recognized gain under §1033 can never exceed the realized gain. Even if the taxpayer pockets a large portion of the proceeds, gain recognition is capped at the total realized gain.

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Example 8: Direct Conversion

Example: The city condemns Gies Co.'s commercial building and provides a replacement building directly (no cash proceeds). The old building had an adjusted basis of $450,000, and the replacement building has a FMV of $600,000.

Step	Result
Recognized gain	$0 (direct conversion — mandatory nonrecognition)
Basis of replacement building	$450,000 (carries over from old property)

In a direct conversion, the taxpayer never has access to cash, so there is no opportunity to "cash out." Gain is fully deferred by definition.

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Determining Taxable vs. Nontaxable Transactions

Framework for Reviewing Transactions

When presented with a property disposition on the TCP exam, use the following decision framework:

Key Documentation to Review

When evaluating whether a transaction qualifies for nonrecognition, the following documents and facts are critical:

Document / Fact	What to Look For
Deed / title transfer records	Confirms real property was transferred — needed for §1031 qualification
Exchange agreement / QI agreement	Confirms a qualified intermediary was used and the exchange structure is valid
45-day identification letter	Confirms replacement property was identified within 45 days (deferred exchanges)
Closing statements / settlement sheets	Shows amounts paid, boot received, mortgages assumed or relieved
Insurance claim / condemnation award	Confirms involuntary conversion event and proceeds received
Replacement property purchase agreement	Confirms cost and date of replacement — needed to verify the replacement period
Appraisals	Supports FMV of properties exchanged — important for related party transactions
Holding period records	Verifies property was held for business/investment use (not personal use or inventory)

Comparison: Taxable Sales vs. §1031 vs. §1033

Feature	Taxable Sale	§1031 Like-Kind Exchange	§1033 Involuntary Conversion
Trigger	Voluntary sale for cash	Exchange of like-kind real property	Casualty, theft, condemnation
Gain recognition	Full gain recognized	Gain recognized only to extent of boot received	Gain recognized only to extent proceeds not reinvested
Loss recognition	Allowed (subject to limitations)	Not allowed — loss deferred	Allowed for casualty/theft losses (subject to limitations)
Election required?	N/A	No — mandatory if requirements met	Yes — taxpayer must elect §1033
Replacement property	N/A	Like-kind real property	Similar use (or like-kind for condemned real property)
Time requirements	N/A	45-day ID / 180-day receipt	2 years (general) or 3 years (condemned real property)
Basis of new property	Cost	Adjusted basis of old property ± boot ± gain recognized	Cost − deferred gain
Holding period	Starts new	Tacks from old property	Starts new (unless direct conversion)

danger

A common exam trap: §1031 defers losses — they are never recognized in a like-kind exchange. In contrast, casualty and theft losses from involuntary conversions may be recognized under the casualty loss rules (subject to floors and limitations). If the exam presents an exchange of like-kind property at a loss, the answer is always no loss recognized.

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Example 9: Classifying a Transaction

Example: Illini Entertainment receives a letter from the county stating it intends to condemn a parking lot (adjusted basis $120,000) for a public park. In response, Illini Entertainment sells the parking lot to the county for $200,000 and uses $185,000 to buy a replacement parking lot within 2 years.

This qualifies as an involuntary conversion under §1033 — a sale under threat of condemnation is treated as a condemnation. Because the condemned property is real property used in business, the replacement period is 3 years and the replacement standard is like-kind.

Step	Calculation	Amount
Amount realized		$200,000
Adjusted basis		$120,000
Realized gain	$200,000 − $120,000	$80,000
Cost of replacement		$185,000
Proceeds not reinvested	$200,000 − $185,000	$15,000
Recognized gain	min($15,000, $80,000)	$15,000
Deferred gain	$80,000 − $15,000	$65,000
Basis of replacement lot	$185,000 − $65,000	$120,000

Exam Tip

A threat of condemnation qualifies for §1033 treatment just like an actual condemnation — but the taxpayer must have been informed in writing or have reasonable grounds to believe the condemnation is imminent. A mere rumor is not sufficient.

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Example 10: Transaction That Does NOT Qualify

Example: Jamie owns investment land (adjusted basis $90,000, FMV $160,000). Jamie sells the land to an unrelated buyer for $160,000 cash and uses the proceeds to buy different investment land for $160,000 three months later.

This is a taxable sale, not a like-kind exchange or involuntary conversion:

• Not §1031: Jamie sold the land for cash. There was no exchange of properties and no qualified intermediary holding the proceeds. A sale followed by a separate purchase is not a like-kind exchange.
• Not §1033: The disposition was voluntary — there was no casualty, theft, or condemnation.

Jamie recognizes the full $70,000 gain ($160,000 − $90,000), and the basis of the new land is its cost of $160,000.

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Summary

Concept	Key Rule
§1031 — Qualifying property	Real property held for business or investment only (post-TCJA); personal property no longer qualifies
§1031 — Recognized gain	Lesser of boot received or realized gain; loss is never recognized
§1031 — Basis of new property	Adjusted basis of old property − boot received + boot given + gain recognized
§1031 — Holding period	Tacks from relinquished property
§1031 — Deferred exchange deadlines	Identify replacement property within 45 days; receive within 180 days (or tax return due date, whichever is earlier)
§1031 — Related party rule	Both parties must hold replacement property for 2 years or the exchange is disqualified
§1033 — Qualifying events	Casualty, theft, condemnation, or threat of condemnation
§1033 — Election	Taxpayer must elect to defer gain (unlike §1031, which is mandatory)
§1033 — Recognized gain	Proceeds not reinvested in qualifying replacement property (capped at realized gain)
§1033 — Basis of replacement property	Cost of replacement property − deferred gain
§1033 — Replacement period	2 years (general); 3 years (real property condemned for business/investment use)
§1033 — Replacement standard	Similar or related in service or use (general); like-kind for condemned real property
Taxable vs. nontaxable	Voluntary cash sales are taxable; like-kind exchanges defer gain; involuntary conversions defer gain if reinvested