Module Overview

Although the general rule is that gain or loss is recognized on disposal, the Internal Revenue Code provides several provisions that defer or eliminate immediate recognition. These nontaxable dispositions permit taxpayers to change the form or use of property without triggering immediate tax on built‑in gain, while often producing special basis or holding‑period consequences. Transactions involving related parties are governed by separate rules that can restrict the timing or deductibility of losses and affect basis and character outcomes. This module summarizes common nonrecognition provisions, explains their typical tax consequences for basis and holding periods, and outlines the principal related‑party limitations students should understand.

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.

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 Transaction and Limitations

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.

IRC §267 disallows losses on sales or exchanges between related parties; disallowed losses are deferred until the buyer disposes of the property in a transaction with an unrelated party. The Code and regulations define related‑party relationships broadly and include family members, certain controlled entities, and related business interests. In addition, transactions that shift income among related parties may be recharacterized under doctrines and provisions that address constructive ownership, assignments of income, and economic substance.

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. For example, although like‑kind exchange treatment under IRC §1031 permits deferral of gain where property used in a trade or business or held for investment is exchanged for qualifying replacement property, Section 1031(f) specifically addresses related‑party exchanges. If the transferee in a §1031 exchange disposes of the replacement property within two years to a related party (with limited exceptions), the original exchange’s nonrecognition treatment can be disallowed, causing recognition of gain as if the intermediate transfer had not qualified for deferral. This rule prevents related parties from arranging exchanges followed by prompt dispositions that would otherwise convert what should be taxable sales into tax‑free exchanges.

Related‑party rules interact with basis, holding‑period, and substitution‑of‑basis regimes, so practitioners must compute whether any disallowed loss, substituted basis, or deferred gain arises and how it will affect subsequent tax events.