A 1031 Exchange provides a tremendous tax benefit to commercial real estate investors – it allows them to defer capital gains taxes on the profitable sale of an asset as long as the sale proceeds are reinvested into another property of “like kind.” But, 1031 Exchanges are complicated transactions with a lot of rules that must be followed to receive full tax deferral.
In this article, we are going to discuss one such rule that has an important impact on the taxes due, the difference between a realized gain and a recognized gain. In doing so, we will define each of these terms, identify their key differences, and discuss the advantages of each. By the end, readers will be able to recognize the difference between these terms and incorporate this knowledge into their pre-investment due diligence process.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers. In the course of our normal business, we have developed a significant expertise in helping 1031 Exchange investors place their funds into suitable replacement property. If you are an accredited investor and would like to learn more about our current opportunities, click here.
What is a 1031 Exchange?
In order to understand the difference between a realized gain and a recognized gain, it is first important to understand what a 1031 Exchange is.
Again, a 1031 Exchange is a tax deferral program that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the proceeds into another property that is considered to be like kind. For the purposes of this transaction, a “gain” is defined as the difference between a property’s cost basis and the sales price. So, for example, if a property had a tax basis of $1MM and a sales price of $2MM, the difference of $1MM is considered to be a gain and it is taxable.
With this context, the definition of a recognized gain vs. a realized gain can be described as follows.
What is a Realized Gain?
For income tax purposes, the key point to remember with regard to a realized gain is that it occurs when a property is sold. In other words, a property may have a gain on the books, but it is not “realized” until it is sold. In the example described above, the realized gain is the $1MM difference between the cost basis in the property and the sales price. But, this does not necessarily mean that the tax liability is calculated on this exact amount. There may be other factors that increase/decrease this amount.
What is A Recognized Gain?
A recognized gain is the taxable portion of a realized gain. The math used to calculate the recognized gain can be complex and should be left to a tax professional, but we will provide a very simple example here.
Suppose that a commercial investor acquired a retail center for a purchase price of $1,000,000. To fund this purchase, they used $200,000 of their own money and got a loan for $800,000. To close the sale, they also paid $50,000 in due diligence and closing costs. So, at the time of purchase, their cost basis is ($200,000 + $800,000 + $50,000) $1,050,000.
Now suppose that the investor holds the property for five years, over which time they take a total of $100,000 in depreciation expense, reducing their cost basis to $950,000 because of the depreciation taken over time.
Finally, suppose that the investor receives an offer for the commercial rental property with a proposed selling price of $1,500,000. In this case, the realized gain is the difference between the cost basis and sales price, $550,000 ($1,500,000 – $950,000).
There are two ways that a real estate investor could deal with this realized gain. First, they could do nothing which would mean that the realized gain would also become the recognized gain, and there will be tax consequences. Or, an investor could attempt to complete a 1031 Exchange by investing the sales proceeds from the “relinquished property” into a new, like-kind property. As long as all of the 1031 Exchange rules are followed, the recognized gain could be as low as $0, which means that the investor/taxpayer is able to defer taxes on the long term capital gain. This is the primary benefit of a 1031 Exchange.
The key point to remember is that: (1) the recognized gain is the taxable portion of the realized gain and it could be the same; and (2) the calculation of the recognized gain can be complicated, and it is best left to an expert in tax law and/or CPA.
Key Differences Between a Realized Gain and Recognized Gain
There are three differences between realized gains and recognized gains that real estate investors should be aware of.
Difference #1: Revenue
An easy way to think about Realized Gains is as the profit on a sale because it takes into account the total costs (the purchase price) in the deal.
An easy way to think about the recognized gain is as the revenue earned from the sale of an asset.
So, the profit in a realized gain is the money that is left over after all fees, taxes, and costs have been deducted from the recognized gain.
Difference #2: Taxation
When a property is sold with a gain, there are tax consequences. Per IRS rules, it produces taxable income, which means that taxes must be paid on it. So, the amount of the gain is a primary driver of the amount of money that will be owned when filing an individual tax return.
The realized gain is the amount that is taxable. In the example above, it is $550,000.
But, the recognized gain can differ because investors can take steps to reduce the amount of the realized gain. One of the most notable steps is a 1031 Exchange, which can effectively reduce the recognized gain to zero.
It is important to note that it is within the realm of possibility that, for tax purposes, the realized gain and the recognized gain could be the same if there are no steps taken to defer it.
Difference #3: Calculation
As described in the example above, the calculation of the realized gain is dependent upon the difference between the cost basis and the sales price. With the help of a tax professional, this is a fairly easy calculation.
The calculation of the recognized gain can be much more complicated. It may involve costs, depreciation recapture, or a 1031 Exchange. Even for an experienced tax professional, this may still be a complex calculation.
Advantages of Realized Gains
The best news about “realizing” a gain on sale is that the seller made a profit.
The other notable benefit is that it may include non-taxable earnings, which can reduce the amount of the gain for tax purposes. The rules around non-taxable earnings are defined in the internal revenue code.
Realized & Recognized Gains in Real Estate Investing
As we have mentioned several times in this article, realized vs. recognized gains is a nuanced and complex topic. But, understanding it can have a significant impact on the tax consequences in a real estate transaction. For this reason, it is important for individual investors to take the time to study these sorts of details as part of the pre-investment due diligence process.
But, it is understood that it can take years of experience and dozens of successful transactions for individual investors to gain the knowledge required to understand this nuance. For this reason, it may be a good idea for some individual investors to partner with an experienced real estate firm and/or a Qualified Intermediary (QI) when completing a 1031 Exchange.
Summary of Realized and Recognized Gains
When a commercial real estate asset is sold for a profit, it produces a “gain” that is taxable. For potential commercial investors, there are two types of gains that should be considered.
A “realized gain” occurs when the sales price is greater than the cost basis.
A “recognized gain” is the amount of the gain that is taxable. The tax treatment of a recognized gain can vary based on a number of factors, including the amount of gain, tax rate, and tax year.
In a 1031 Exchange, a common real estate transaction, the recognized gain can be reduced to $0 as long as the sales proceeds are reinvested into another property that is considered to be ““like kind.”
There are important and complex nuances to this type of transaction. For this reason, it may be a good idea for individual investors to partner with an experienced and professional real estate firm and/Qualified Intermediary to execute a 1031 Exchange.
Interested In Learning More?
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If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.