26.3 Like-Kind Exchanges, Involuntary Conversions, and Installment Sales

Deferral Is Not Exclusion

A deferral transaction postpones recognition; it does not erase gain. The 2026 TCP Blueprint names like-kind exchanges, involuntary conversions, and installment sales as property-disposition tasks and expects candidates to calculate realized gain, recognized gain, deferred gain, and the basis in the replacement asset or installment obligation. The deferred gain survives as a lower (substituted) basis, so it is taxed on the eventual sale.

Simulations hand you a full document set — closing statement, exchange agreement, insurance settlement, promissory note, depreciation schedule, and a draft form. Your job is to decide whether the transaction qualifies for deferral, then measure the current-year tax.

Three Deferral Regimes

Section 1031 Like-Kind Exchanges

Section 1031 now applies ONLY to real property held for productive use in a trade or business or for investment (verified 2026 — the Tax Cuts and Jobs Act removed personal property in 2018). Inventory, dealer property, a personal residence, securities, and partnership interests do not qualify. U.S. real property and foreign real property are NOT like-kind to each other.

A delayed exchange has two hard, non-extendable deadlines, both running from the relinquished property's closing date: written identification of replacement property within 45 days, and receipt of the replacement within 180 days (the 180 runs concurrently, not after the 45).

Recognition rule: recognized gain = lesser of realized gain or boot received. Boot is cash plus non-like-kind property; net debt relief is treated as boot unless offset by debt assumed or cash paid. Deferred gain = realized gain − recognized gain. Basis shortcut: replacement basis = its fair market value − deferred gain. Example: realized gain $120,000, cash boot $20,000 received → recognized $20,000, deferred $100,000.

Section 1033 Involuntary Conversions

An involuntary conversion is property destroyed, stolen, condemned, or sold under threat of condemnation. If the taxpayer reinvests the insurance or condemnation proceeds in qualifying replacement property within the replacement period (generally 2 years after the close of the gain year, 3 years for condemned business/investment real property), gain is deferred. Replacement must meet the applicable similarity standard.

Recognition is limited to proceeds not reinvested, capped at realized gain. Full reinvestment defers all gain and reduces replacement basis. Unlike Section 1031, Section 1033 can be elective and does not require a qualified intermediary or 45/180 mechanics.

Installment Sales

An installment sale exists when at least one payment is received after the year of sale (Section 453). The core formulas:

• Gross profit percentage = gross profit ÷ contract price.
• Current-year gain = principal payments received × gross profit percentage.
• Stated or imputed interest is reported separately, never as sale gain.

Key trap: depreciation recapture is NOT deferred — all Section 1245/1250 recapture is recognized in the year of sale even if no cash is collected, and that recapture increases the property's basis for computing gross profit. Dealer sales, inventory, publicly traded securities, and certain related-party resales are blocked from or modified under the installment method.

CPA Exam Workflow

1. Compute realized gain (amount realized − adjusted basis).
2. Identify the deferral statute and confirm qualifying property.
3. Separate boot, net debt relief, insurance proceeds, principal, and interest.
4. Recognize recapture immediately when required.
5. Compute deferred gain and replacement basis, or the installment gross profit percentage.
6. Tie out to Form 8824 (exchanges), Form 6252 (installment), and Form 4797 (business assets).

The safest habit: LABEL every dollar before calculating. A cash receipt may be boot, insurance proceeds, down-payment principal, or interest — and the tax result flips with the label.

Boot, Debt Relief, and Replacement Basis in Detail

Debt relief trips up many candidates. In a Section 1031 exchange, a mortgage the taxpayer is RELIEVED of counts as boot received; a mortgage the taxpayer ASSUMES on the replacement property counts as boot given. Only the NET debt relief is boot, and net debt relief can be offset by cash the taxpayer pays in — but cash received can never be offset by debt assumed. Example: taxpayer gives up property with a $40,000 mortgage and takes replacement property with a $25,000 mortgage; net debt relief is $15,000 of boot. If the taxpayer also pays $5,000 cash into the deal, that $5,000 reduces the boot to $10,000.

Replacement basis can be computed two equivalent ways: (1) fair market value of the replacement minus deferred gain, or (2) basis of property given up, plus boot paid and gain recognized, minus boot received. Both reproduce the deferred gain inside the new asset's basis. The exam may give you either set of inputs, so practice both directions.

Installment Method Mechanics and Recapture

Return to the installment regime with recapture layered in. Suppose a taxpayer sells equipment for $100,000 (a $60,000 note payable over five years plus $40,000 down). Adjusted basis is $30,000, and $50,000 of accumulated depreciation means $50,000 of potential Section 1245 recapture. Recapture is recognized IN FULL in the year of sale — even though only $40,000 cash arrived — and that recapture is added to basis for the gross-profit computation.

So the recapture flushes the ordinary income out immediately, and only the remaining gain (gain above original cost, the true capital/Section 1231 piece) is eligible for installment deferral across the note payments. This interaction is a favorite simulation twist: candidates who spread the depreciation recapture over the note years get it wrong.

Finally, remember the election mechanics. The installment method is automatic for qualifying sales, but a taxpayer may elect out on a timely filed return to recognize all gain in the year of sale — useful when the seller has expiring losses or expects higher future rates. Section 1031 deferral, by contrast, is mandatory if the transaction qualifies; you cannot choose to recognize gain on a like-kind exchange the way you can elect out of installment reporting.