Revenue Code 1002 and the Recognition of Gain or Loss
Gain insight into the tax framework for property dispositions. Learn how the tax code determines if a realized gain or loss must be claimed now or can be deferred.
When property is sold or exchanged, the disposition of an asset can trigger a taxable event. The owner must consider the potential for a taxable gain or a deductible loss. The Internal Revenue Code (IRC) provides a structured framework for these events, starting with determining if a gain or loss has occurred and then establishing how much must be reported.
The General Rule of Recognition
Recognition is the act of including a gain or loss on a tax return for the current year. The default rule under the tax code is that the entire amount of a realized gain or loss from a sale or exchange must also be recognized. This means the financial outcome of the transaction must be reported to the IRS unless a specific exception applies. This principle was historically in IRC Section 1002, which was repealed by the Tax Reform Act of 1976. The rule for full recognition now resides in IRC Section 1001, which states that the entire gain or loss from a property sale shall be recognized.
Calculating Gain or Loss
Before a gain or loss can be recognized, it must be calculated. The calculation uses a formula: the Amount Realized from the sale minus the property’s Adjusted Basis equals the Realized Gain or Loss. The result is the financial outcome of the transaction.
The “Amount Realized” is the total value received in the disposition. This includes cash paid by the buyer and the fair market value of any other property or services received. It also encompasses any of the seller’s debts assumed by the buyer. For instance, if a buyer pays cash for a building and also takes over the existing mortgage, the mortgage amount is part of the seller’s amount realized.
“Adjusted Basis” starts with the property’s original cost to the owner. This initial basis is increased by the cost of capital improvements and decreased by any depreciation deductions claimed over the years. For example, if a business owner bought a machine for $50,000, spent $5,000 on an upgrade, and claimed $10,000 in depreciation, the adjusted basis would be $45,000. If this machine were then sold for $60,000, the realized gain would be $15,000 ($60,000 Amount Realized – $45,000 Adjusted Basis).
Common Nonrecognition Provisions
Congress has created exceptions to the general recognition rule called “nonrecognition provisions.” These rules allow taxpayers to defer a gain or loss, often because the taxpayer has continued their investment in a different form instead of cashing out. These provisions do not eliminate the tax; they defer it by carrying over the old property’s basis to the new property.
A well-known exception is the like-kind exchange under IRC Section 1031. This provision allows an owner of real property held for business or investment to defer gain recognition if they exchange it for another piece of qualifying real property. Since the Tax Cuts and Jobs Act of 2017, this treatment is limited to real property and no longer applies to personal property.
IRC Section 1033 deals with involuntary conversions. If a property is destroyed, stolen, or condemned, the owner may defer any resulting gain by acquiring a similar replacement property within a specific period, typically two to three years.
IRC Section 351 permits individuals to transfer property to a corporation in exchange for stock without recognizing gain or loss, provided they control the corporation immediately after the transfer. This rule allows founders to contribute assets to a corporate entity without an immediate tax consequence.