I was talking with a friend of mine who is an investment banker about a recent 1031 exchange. I mentioned that my client was pleased he wouldn’t face any taxable recognized gain for the foreseeable future. When I said “recognized gain,” my friend gave me a look and asked: “Don’t you mean realized gain?”
In real estate, it’s often the case that subtle differences of expression can have a substantial impact. This is clearly illustrated with the terms “realized gain” and “recognized gain.” These terms are quite distinct and have different implications. As an investor, you want to be fully aware of how these terms differ so that you can be adequately prepared for your 1031 exchange.
Realized vs. Recognized Gain: The Taxable Difference
To put it simply, your realized gain represents the benefit you receive when you sell your property. This is the case whether you sell your property as part of a traditional sale or as part of one step in a deferred 1031 exchange. To calculate your realized gain, you take the net sales price—that is, the sale price of the real estate minus closing costs—and subtract the adjusted tax basis in the real estate. Your gain reflects the amount of money you receive subtracted by your investment in the real estate and its underlying value.
On the other hand, your recognized gain is the taxable portion of your realized gain. In a traditional sale where one takes the sale proceeds in cash, your recognized gain will typically be the same as your realized gain because you will incur a tax liability by way of the transaction. However, as we know in a 1031 exchange, it is possible to defer your tax liability, so a successful 1031 exchange will yield a recognized gain at the time of sale that is effectively zero. Even in such a scenario, however, you will still have a realized gain even if your recognized gain is zero because your tax liability is deferred.
Where Does Boot Fit In?
As we’ve stated, realized gain represents your benefit while recognized gain represents your liability. And in a properly executed 1031 exchange, you should not incur any recognized gain. If boot results from a partial 1031 exchange (partial exchange and partial cash-out), then it is possible to have a recognized gain even though the majority of your tax liability is deferred.
Calculating Realized and Recognized Gain: An Example
These concepts may seem simple at first glance, but let’s look at a quick example to get a better sense of how these terms play out.
Suppose you own a piece of property that has a fair market value of $200,000 and an adjusted tax basis of $120,000. You’d like to swap this property as part of a 1031 exchange for another property with a market value of $180,000. For the sake of simplicity, we will assume that neither property is encumbered by any pre-existing mortgage debt or other liabilities. Because the replacement property is worth $20,000 less than your relinquished property, the owner of the replacement property gives you $20,000 in cash to make up for the difference.
In this scenario, you would have a realized gain of $80,000 because you acquired a property with a fair market value of $180,000 and then received cash boot of $20,000. Adding these together, you received $200,000 in total value and had an adjusted tax basis of $120,000.
To compute your realized gain, you would subtract your adjusted tax basis in your relinquished property from the $200,000 you received ($200,000 - $120,000 = $80,000). But in this case, your recognized gain would only be $20,000 because you would have $20,000 in boot because you acquired a property that was valued at $20,000 less than the relinquished property. The remaining $60,000 of gain would be deferred and then potentially recognized at a later date should you choose to sell your new property and take the sale proceeds in cash.
Real Estate Investment Management Firm with 1031 Exchange Expertise
Understanding the difference between realized and recognized gain can have a great deal of impact on an investor. The more real estate terminology you understand, the more confident you will be in approaching transactions. At CWS Capital Partners, our team of real estate investment professionals are experts in 1031 exchanges. Contact us today to take the first step on your 1031 exchange journey.
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