While the general rule is that gain or loss is recognized upon the disposition of property, the Internal Revenue Code provides several exceptions where gain or loss may be deferred or not recognized immediately. These are often referred to as nontaxable dispositions. Additionally, transactions between related parties are subject to special scrutiny and rules that can impact the recognition and character of gains and losses. This chapter will explore these concepts, including basic definitions, gain and loss deferral mechanisms, and the determination of basis in these situations.

These are specific types of property transfers where the tax law allows for the postponement of recognizing a gain or loss. The rationale behind these provisions often involves situations where the taxpayer’s economic position has not fundamentally changed, even though a formal disposition has occurred. The goal is often to facilitate business restructurings, involuntary events, or like-kind exchanges without triggering immediate tax liabilities. The gain or loss is typically deferred until a later taxable disposition of the new property.  

Several sections of the IRC allow for the deferral of gain or loss in specific types of property dispositions:  

Like-Kind Exchanges (§ 1031):

This section allows for the deferral of gain or loss when real property held for productive use in a trade or business or for investment is exchanged for other real property of a like kind. The underlying principle is that the taxpayer has merely changed the form of their investment, not liquidated it.

• Like-Kind Requirement: The exchanged properties must be of the same nature or character, even if they differ in grade or quality. Most exchanges of real property for other real property qualify. Personal property has stricter “like-class” requirements.
• Boot: If the taxpayer receives “boot” (money or non-like-kind property) in the exchange, gain is recognized to the extent of the boot received (IRC Section 1031(b)). Loss is generally not recognized in a like-kind exchange where boot is received (IRC Section 1031(c)).   
• Deferred Gain/Loss: The gain or loss that is not recognized is effectively deferred because the basis of the new property is generally the same as the basis of the old property, adjusted for any boot received or gain recognized.

Involuntary Conversions (§ 1033):

This section allows for the deferral of gain when property is involuntarily converted (e.g., due to destruction, theft, seizure, condemnation, or threat of condemnation) and the taxpayer reinvests the proceeds in qualified replacement property within a specified period. This provision aims to ease the burden on taxpayers who are forced to dispose of property due to circumstances beyond their control.

• Qualified Replacement Property: The replacement property must be similar or related in service or use to the converted property (with a broader definition for business or investment real property in certain cases).  
• Gain Recognition: Gain is recognized only to the extent that the amount realized from the conversion exceeds the cost of the replacement property. Loss is generally recognized.
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Basis rules for property acquired in nontaxable transactions

The deferral of gain or loss in a nontaxable property transaction directly impacts the basis of the asset received by the party in the exchange. The underlying principle is to preserve the unrecognized gain or loss so that it is accounted for in a future taxable disposition. In many common nontaxable transactions, such as like-kind exchanges under IRC Section 1031, the basis of the old property is carried over to the new, or replacement, property.

This is often subject to adjustments. For instance, if a party receives “boot,” which is cash or non-like-kind property, in addition to the like-kind property, gain may be recognized to the extent of the boot received. In such cases, the basis of the new property is calculated as the basis of the old property, decreased by the amount of boot received and increased by the amount of gain recognized on the exchange.

Similarly, in involuntary conversions where gain is deferred under IRC Section 1033 by reinvesting the proceeds into similar property, the basis of the replacement property is generally its cost, reduced by the amount of gain that was not recognized. This ensures that the deferred gain will be taxed when the replacement property is eventually sold in a taxable transaction. Even in related-party transactions where losses may be disallowed under IRC Section 267, the disallowed loss can sometimes be used by the related party who acquired the property to reduce any gain they might subsequently realize on its sale. In essence, the basis adjustments in nontaxable transactions are a mechanism to track and eventually account for the economic gain or loss that was not taxed or deducted at the time of the initial exchange.

Related Party Status Can Trigger Specific Rules and Limitations on Nontaxable Dispositions

While nontaxable dispositions can occur between related parties, the IRC contains specific provisions that modify or restrict the application of nonrecognition rules in such contexts to prevent tax avoidance:

• Related Parties: The tax law defines specific relationships that are considered “related parties.” Transactions between these parties are subject to special rules due to the potential for abuse or tax avoidance. These relationships are defined in various sections of the IRC, including § 267 (Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers) and § 707(b) (Certain Sales or Exchanges of Property With Respect to Controlled Partnerships). Common examples of related parties include family members (spouse, siblings, ancestors, lineal descendants), and entities controlled by the same individuals. 

• Loss Disallowance (§ 267(a)): A significant interaction occurs when a loss is realized on the sale or exchange of property between related parties. Even if the transaction might otherwise resemble a disposition that could be nontaxable (though loss recognition is generally the point of contention here), § 267(a) generally disallows the deduction of such losses. For instance, if a parent sells property at a loss to their child, even if it were part of a transaction that might otherwise have some nonrecognition aspects, the loss would likely be disallowed. The disallowed loss may be allowed to the related party buyer when they subsequently sell the property at a gain, but only to the extent of that gain.
• Like-Kind Exchanges (§ 1031(f)): While § 1031 allows for the nonrecognition of gain in like-kind exchanges, § 1031(f) imposes specific rules for exchanges between related parties. If a related party disposes of the property received in the exchange within two years of the date of the last transfer that was part of the exchange, the original nonrecognition of gain or loss may be negated, and the gain or loss on the original exchange may be recognized as of the date of the subsequent disposition. This rule prevents related parties from engaging in like-kind exchanges with the primary purpose of immediately selling the acquired property without tax consequences.  
• Gain Characterization (§ 1239): Although a transfer to a controlled entity under § 351 might be nontaxable at the time, a subsequent sale of depreciable property between certain related parties (e.g., an individual and a corporation they control) can result in any gain being treated as ordinary income under § 1239, rather than capital gain. This prevents the transferor from recognizing capital gain while the related party buyer gets a stepped-up basis for depreciation deductions against ordinary income.  
• Transactions Between Partnerships and Controlling Partners (§ 707(b)): This section contains rules similar to § 267 and § 1239 specifically for transactions between a partnership and a partner who owns, directly or indirectly, more than 50% of the capital or profits interest in the partnership. Losses on sales or exchanges of property between a partnership and a controlling partner are disallowed, and gains from the sale or exchange of property between a partnership and a controlling partner are treated as ordinary income if the property is not a capital asset in the hands of the transferee.

Tax authorities generally scrutinize transactions between related parties more closely to ensure they are bona fide and not solely aimed at tax avoidance. The arm’s-length principle is often applied to ensure that the terms and conditions of the transactions are comparable to those that would occur between unrelated parties.