Is there any way I can avoid the federal income tax? What are some non-recognition provisions?
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UPDATED: Jul 16, 2021
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Some of the more common nontaxable sales or exchanges are what are called “like kind” exchanges of investment property, which can be involuntary conversions (such as condemnation, fire loss, etc.) replaced with like-kind property, repossession of real property after default, and certain exchanges of life insurance contracts. These are examples of sales or exchanges that are nontaxable, a status that is conferred upon them by nonrecognition provisions.
In general, the IRS is only interested in value retained from sales or services. If the sale or service you are involved in does not result in any gain to you, then it is nontaxable. Also, if the sale or service does not have a specified value, there is nothing to list on your taxes.
The first type of unrecognized income is a like-exchange. For example, if your car is totaled in a car accident and the insurance company provides you with the equivalent value of the car to pay for your replacement, you do not need to report the money the insurance company gave you. This is because the money is going directly to replace one item of value with another equivalent item.
Another example of a non-recognized income is a “wash” sale. In a wash sale, an item of value is sold for below its actual value, but for enough to cover any associated sales costs. For instance, you purchased and refurbished an antique table and its new value is $10,000. However, you are only able to sell it for your original purchase price of $2,000. The sale is a wash for you and you do not need to report the income.
Likewise, you cannot report repossession of defaulted property as a loss on your taxes. So, if you default on your mortgage and your home is foreclosed, you cannot report the amount of money you had already paid for the home as a “loss” on your taxes.
Determining non-recognized income is a tricky process. If you are unsure whether your transactions fall into this category, consult a tax attorney.