7854 / Do the rules that apply in excluding gain from the sale or exchange of a taxpayer’s principal residence apply in the case of an involuntary conversion?

For purposes of the exclusion of gain on the sale or exchange of a principal residence, the destruction, theft, seizure, requisition, or condemnation of property is treated as a sale or exchange. For purposes of applying IRC Section 1033 (involuntary conversions), the amount realized from the sale or exchange of the taxpayer’s principal residence is equal to the amount of gain (determined without regard to this exclusion), reduced by the exclusion. If the basis of the property acquired as a result of an involuntary conversion is determined, in whole or in part, under the involuntary conversion rules, the holding period and use by the taxpayer of the converted property will be treated as the holding and use by the taxpayer of the property sold or exchanged.¹ The Service has determined that for purposes of IRC Section 121(d)(5), the question of whether the “destruction” of a taxpayer’s principal residence has occurred is a question of fact.²

Following several national disasters, such as Hurricane Katrina, Congress extended from two to five years the replacement period in which a taxpayer could replace property that was located in the disaster area and that was compulsorily or involuntarily converted. The extended replacement period applied only if substantially all of the use of the replacement property was in the disaster area.³