Every real estate investor or property owner should be familiar with a couple of key concepts: “Realized Gain” and “Recognized Gain.” Although they sound similar, they are vastly different—and knowing the difference can dramatically impact your bottom line.
Simply put, this is the amount of gain an investor makes from selling an asset. It’s calculated as the net sales price received (sales price of the asset less any closing or transaction costs) less the owner’s adjusted tax basis in the asset. This is essentially what the owner originally paid for the asset, less any depreciation deductions the owner claimed during ownership.
This is the taxable portion of a realized gain. With proper planning and execution of a 1031 exchange, it can be deferred. This means you can put off paying costly capital gains taxes. With continued exchanges and a bit of estate planning, you may be able to avoid ever recognizing your realized gains at all.
Let’s walk through an example to more fully understand these concepts. Let’s assume that Bob and Mary bought an investment property four years ago for $2,000,000. They invested $600,000 of their own cash and took out a mortgage for $1,400,000 to finance the purchase. They also paid for due diligence, loan fees, and other closing costs in the amount of $35,000. After holding this investment property for four years, their adjusted tax basis would look something like:
|Cash Equity Paid by Buyer||600,000|
|Due Diligence Costs Paid by Buyer||20,000|
|Loan Fees and Other Closing Costs||15,000|
|Buyer's Tax Basis at Closing||2,035,000|
|Depreciation Taken Year 1||(50,000)|
|Depreciation Taken Year 2||(50,000)|
|Depreciation Taken Year 3||(50,000)|
|New Roof in Year 3||20,000|
|Adjusted Tax Basis||$1,905,000|
Bob and Mary now have an offer to sell their property for $2,500,000. Estimating that a sales commission and other ancillary closing costs would run about $50,000, they should net $1,050,000 if they choose to sell.
|Less: Closing Costs||(50,000)|
|Net Selling Price||$2,450,000|
|Less: Payoff of Mortgage Financing||(1,400,000)|
|Net Cash Received on Sale||$1,050,000|
However, the amount of cash received from the sale of their investment property is really not the same as either the realized gain or the recognized gain on Bob and Mary’s proposed sale.
Their realized gain would be:
|Net selling price (from above)||$2,450,000|
|Less: adjusted tax basis||(1,905,000)|
But often times real estate property owners fail to do proper tax planning and the recognized gain will equal the entire realized gain. In Bob and Mary’s case, this means they would incur capital gains taxes on the entire $545,000 of their realized gain. Depending upon where their property is located and other income, these capital gains taxes could be in excess of $200,000, or 20%, of their net cash proceeds!
But what if Bob and Mary don’t really need access to this $1,050,000 in cash proceeds from the sale of their property and are planning to re-invest this money? With a little advance planning, they can take advantage of a 1031 exchange and re-invest these cash proceeds in another like-kind investment. Suppose they take $500,000 of these proceeds and buy another investment property? If so, their recognized gain is far different.
If Bob and Mary are willing to re-invest their entire cash proceeds into a new like-kind asset they can even reduce the recognized gain to zero, thereby deferring 100 percent of the capital gains taxes that would be due on the sale of their property.
It's important to note that the exchange process is a bit more complicated than this simple example. To get a more detailed understanding of a what an exchange could mean for you, download our Realized 1031 Exchange Calculator to get the whole picture.
Obviously, we at Realized believe that realized gains are much more attractive than recognized gains—hence our name, and why it’s key that real estate investors understand the distinction.