Capital Gain: Realized vs Recognized Gain

Investment

Every real estate investor wants to make money from the sale of his or her assets. When you put your time, energy, and money into acquiring and looking after a property, the last thing you want is to take a loss. Fortunately, through a 1031 Exchange, investors everywhere can make the most of their investment properties.

At NNN Deal Finder, we make it our goal and objective to help investors, new and experienced, make the most of their real estate assets. With an entrenched network of realtors, brokers, contractors, inspectors, and more, we can assist clients throughout the 1031 Exchange process.

If you’re an investor looking to make sense of your profit from a sold asset or assets, you need to understand gain. Recognized gain and realized gain are the two types of gain every investor needs to know.

What is Realized Gain?

The distinction between realized gain vs recognized gain is crucial to keeping good financial records, making durable, profitable investments, and adhering to associated rules and regulations.

You can calculate realized gain by subtracting the adjusted tax basis from the net sales price of real estate. The realized gain is the difference between an asset sold at a price higher than its initial purchase price.

This is one of the key differences.

In 1031 Exchanges, most investors seek to eliminate any potential recognized gain. By exchanging for “like-kind” replacement properties, investors can effectively defer all capital gains taxes.

If the replacement property has an equal or greater value than the relinquished property, total tax deferment can occur. Thus, nothing is taxed at the time, and there is no recognized gain or tax liability in the sale.

Calculating Realized Gains

The entire realized gain on a real estate asset depends upon multiple factors, including purchase price, tax basis, closing costs, brokerage fees, and more. In other words, the realized gain is the net sales price minus this tax basis.

What is Adjusted Tax Basis?

Simply put, this adjusted basis is the original purchase price of the real estate asset, in addition to acquisition costs and capital improvements, minus depreciation deductions and prior capital gain taxes deferred.

This can be confusing for real estate investors, so the terms must be fully understood.

Firstly, there are capital improvements. These improvements are important realized gain considerations, especially when calculating tax liability. They are not like normal repairs and receive special consideration from the IRS.

Capital improvements on an investment property must include the following two primary features:

  • They are lasting upgrades, changes, or enhancements that increase value over time and are usually of a structural nature.
  • They usually boost the property’s cost basis, thus reducing the tax burden upon sale.

In factoring capital improvements into the equation, it’s important to remember that simple maintenance fixes and repairs do not qualify under the IRS special treatment category. You must be able to show how the improvements have led to asset value increases.

Calculating Adjusted Tax Basis

Overall, calculating the basis depends on five asset-associated values: purchase price, acquisition costs, capital improvements, depreciation deductions, and prior deferred gains. You can quickly calculate your tax basis once you know these values.

For example, if a real estate investment property has a base price of $1,000,000, with $5,000 in acquisition/closing costs, has $40,000 in capital improvements, $250,000 in depreciation, and $100,000 in deferred property gains, the sale proceeds would be:

$1,000,000 + $5,000 + $40,000 – $250,000 – $100,000 = $695,000

Factoring Realized Gains

To calculate the realized gain on the property, you would deduct this number ($695,000) from the net sales price. In other words, the net sale price minus the adjusted tax basis is the realized gain.

The net sale price is merely the total cost to the buyer, excluding all ancillary costs and fees, such as those for commissions, appraisals, and transactions.

Once you know your realized gains value, you can begin to understand where you may stand in terms of recognized gains from the sale of your asset. Depending upon the net equity in your property, remaining value, and other investment factors, you may have a significant realized gain.

When selling an asset and acquiring a replacement property, it is important to know how the tax laws pertain to both the realized gain and the recognized gain. If an investor makes a mistake, top real estate professionals can assist.

Don’t make crucial errors on taxes under the tax law. Know the difference between what gain is the taxable gain, and what gain can be deferred to a later date.

A fully deferred exchange will require that you reinvest all net equity in addition to replacing the value of all loans paid off in the sale. Debt relief is taxable unless the old debt is replaced with an equal or greater loan, or if the new cash investment is increased by the amount of debt relief.

If you have questions about net equity, relinquished property, taxable gain, or any other example of business and investment property, a seasoned realty expert can assist.

What Is Recognized Gain?

Money calculation

In a 1031 Exchange, recognized gain is the taxable portion of any realized gain. In general terms, recognized gain is simply the profit from the sale of an asset.

Both gains are capital gains, but key differences do exist. One primary difference is that recognized gain may be non-existent in a 1031 Exchange.

This real estate investment mechanism allows the exchanger to defer all capital gains taxes under certain conditions. The replacement property must be similar in nature or class. This means it must be ‘like-kind’ and used for investment purposes.

Determining Recognized Gain

All like-kind property must be of equal or greater value than the relinquished property for total tax deferment. This way, you are using all of your gains from the gross profit to reinvest in the replacement property. These exchange proceeds or sales proceeds may allow you to make a larger down payment than otherwise, assuming a profitable sale.

Thus, the common objective in using a 1031 Exchange is to defer all tax liability for capital gains to invest in bigger, better, more profitable properties. Avoiding such tax consequences is a great benefit, so long as the selling price of the relinquished property is of lesser value than the replacement property.

As Section 1031 states quite explicitly:

No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.

There are, however, many examples where taxpayers and accredited investors may have a taxable portion or ‘boot.’

Money calculation

Mortgage Boot

Sometimes, an investor will have a recognized gain from a new property with a lower value mortgage. This is called the mortgage boot and is essentially the difference in debt owed on the sold property and debt owed on the new property. For example, if your new property’s mortgage is $100,000 and the old property’s mortgage is $80,000, your mortgage boot will be $20,000.

Recognized gains such as this are reported in Form 8824. Do your due diligence and report any taxable income.

Cash Boot

Simply put, cash boot is similar to a mortgage boot because it’s the taxable amount that an exchanger receives after the exchange. One example is if an investor keeps $70,000 of $200,000 in exchange proceeds, he or she is only investing $130,000 in a down payment. The $70,000 is thus taxable.

However, this is different than if a mortgage is paid off and additional cash is used with proceeds to purchase a new property without debt. In this example, there are no taxable recognized gains.

Making the Most of Realized Gains vs Recognized Gains

At NNN Deal Finder, we know what it’s like to struggle with the process. We know what it’s like to be filled with questions and concerns as you take on a 1031 Exchange.

Understanding recognized gain vs realized gain does not have to be difficult. We can help you handle any realized gain or recognized gain based on a 1031 Exchange.

Whether you’re focused on the sales price of a replacement property, trying to build net equity, concerned about selling an asset, or confused about taxable gain, our experts can assist.

Reach out and give us a call. Make the most of your investments today.

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