8681 / In the case of an involuntary conversion of a principal residence, how does the nonrecognition treatment under IRC Section 1033 interact with the exclusion of gain under IRC Section 121?

1. For purposes of determining potential gain for purposes of IRC Section 1033, the amount realized is the fair market value of the relinquished property;
2. Next, the amount of gain that would have been excluded pursuant to IRC Section 121 is subtracted from that amount; and
3. Gain is recognized to the extent that the amount computed pursuant to 2), above, exceeds the cost of a replacement home.¹

Example: Asher, a single taxpayer, has a principal residence with a fair market value of $600,000 and a basis of $250,000. In a storm, Asher’s home is totally destroyed. Asher uses $300,000 of the $600,000 insurance proceeds to purchase a new principal residence. Asher’s regular realized gain would be $350,000 ($600,000 minus $250,000). Of that gain, since Asher is a single taxpayer, he may exclude $250,000.

Step 1 and Step 2. $600,000 insurance proceeds minus the $250,000 gain Asher can exclude pursuant to IRC Section 121 equals $350,000.

Step 3. Asher used $300,000 of the insurance proceeds to purchase a replacement home. However, since $350,000 (Step 1 and Step 2 amount) exceeds that amount by $50,000, the latter amount is included in gross income. ²

Asher’s basis should be computed as follows:

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1. Original basis in home - $250,000
2. Gain recognized - $50,000
3. Gain Excluded - $250,000
4. New Basis - $550,000 (1 plus 2 plus 3).

Thus, Asher’s new home has a fair market value of $300,000 and a basis of $550,000. The difference between the fair market value of the home and the basis reflects the $250,000 of excluded IRC Section 121 gain. In essence, with this higher basis, Asher’s exclusion is preserved. So, if Asher sells the home for up to $550,000, no gain is realized.

1. IRC § 121(d)(5)(B).

2. Rev. Proc. 2005-14, 2005-7 IRB 492.