8664 / What is a nontaxable exchange? What is the difference between a nontaxable exchange and a tax-free transaction?

Editor’s Note: The 2017 tax reform legislation limited the nonrecognition treatment provided under IRC Section 1031 to exchanges of real property that is not held primarily for sale.¹ This provision applies to exchanges occurring after December 31, 2017. An exception exists if either (1) the property involved in the exchange was disposed of on or before December 31, 2017, or (2) the property received in the exchange was received on or before December 31, 2017.² The new rules also provide that real property located within the U.S. and foreign real property are not of a like-kind.³

In certain circumstances, the IRC permits a taxpayer to obtain new property in order to replace previously held property without recognizing gain on the exchange. This nonrecognition treatment reflects Congress’ acknowledgment that, while the taxpayer acquires a new asset in exchange for an existing asset, in substance the taxpayer has not changed economic positions.

In a nontaxable exchange, although gain or loss on the disposition of property is not recognized at the time of the exchange, the nonrecognition treatment is only temporary. Thus, when the taxpayer eventually sells the replacement property, the taxpayer will then be required to recognize gain or loss. On the other hand, in a tax-free transaction, the gain or loss is never recognized. For example, within certain limits the gain on the sale of a taxpayer’s primary residence is excluded from gross income and, thus, never taxed.⁴

A direct exchange is not always necessary in order for a transaction to qualify as a nontaxable exchange. For example, in an involuntary conversion, a taxpayer obtains an asset to replace property that was lost. See Q 8670 to Q 8673 for a discussion of the rules applicable in the context of an involuntary conversion.