Final answer:
Taxpayers can use both §121 gain exclusion and §1033 gain postponement provisions after a principal residence is destroyed in a fire, applying §121 first to reduce the taxable gain, followed by §1033 to defer tax on the remaining gain by reinvesting in qualified replacement property.
Step-by-step explanation:
The subject of the question is the tax treatment of a principal residence destroyed in a fire. When such an event occurs, a taxpayer has options for tax relief under the Internal Revenue Code: §121 (sale of residence gain exclusion) and §1033 (involuntary conversion postponement of gain).
It states that a taxpayer can initially use §121 to exclude a portion of the realized gain from the taxable income -- the maximum exclusion being $250,000 for single filers and $500,000 for joint filers -- which pertains to the capital gains on the sale of a primary residence.
Then, the taxpayer can use the provisions of §1033 to postpone the taxation of the remaining realized gain, by reinvesting in a qualified replacement property within a specific period of time. This suggests that both provisions can be used in conjunction, with §121 first reducing the amount of gain subject to §1033's reinvestment requirement.
The statement that a taxpayer whose principal residence is destroyed in a fire can use either the § 121 (sale of residence gain exclusion) or § 1033 (involuntary conversion postponement of gain) provisions, but not both, is false.
Initially, the taxpayer can elect to exclude the amount of realized gain allowed under § 121. Then, § 1033 can be used to postpone the remainder of the realized gain associated with a qualified replacement. By using § 121 first, the amount of reinvestment needed under § 1033 is reduced.