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.
Understanding the difference between a recognized gain and a realized gain is crucial for reporting income and capital gains accurately. At first glance these two terms may seem interchangeable. However, recognized gains and realized gains have distinct meanings and implications when it comes to accounting and taxes.
In this comprehensive guide, we will break down:
- Definitions of recognized and realized gains
- Key differences between the two
- Examples to illustrate the concepts
- How each type of gain affects taxes
- Frequently asked questions
Grasping these core concepts will ensure you properly categorize, report, and pay taxes on investment gains and profits from selling assets. Let’s dive in!
Definitions
Here are concise definitions of recognized and realized capital gains:
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Realized gain – The actual profit earned when selling an asset or investment for more than its original purchase price or adjusted cost basis It is the basic calculation of the gain realized from the transaction
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Recognized gain – The portion of the total realized gain that is included or “recognized” in taxable income and accounted for in financial statements. Some realized gains may be deferred or excluded from taxable income.
The key distinction is that a realized gain is the total gain realized or earned from selling an asset, while the recognized gain factors in what portion of that total gain gets included in income.
With realized gains, no accounting rules or tax implications are considered. It’s a straightforward mathematical calculation of proceeds less adjusted cost basis.
Recognized gains, on the other hand, must follow accounting principles like GAAP or tax code rules that dictate how much of the total realized amount gets recognized in different income calculations.
Key Differences Between Realized and Recognized Gains
While subtle, these are very important differences when recording gains properly:
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Timing – Realized gains occur at the point of sale when proceeds are received. Recognized gains are reported when income is calculated and may be deferred to future periods.
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Calculation – Realized gains are strictly sale proceeds less adjusted cost basis. Recognized gains factor in amounts excluded or deductions like depreciation.
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Tax implications – Realized gains have no direct tax impact. Recognized gains are the amounts that get included in taxable income and taxed.
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GAAP rules – Realized gains follow no accounting standards. Recognized gains adhere to GAAP revenue recognition principles.
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Concept – Realized gain is an economic concept reflecting profit earned. Recognized gain is an accounting/tax concept including certain gains in income.
While most realized gains become fully recognized, these core differences demonstrate why the terms are not interchangeable. Let’s look at some examples.
Examples of Realized vs Recognized Gains
Let’s use two scenarios to compare realized and recognized capital gains.
Stock Investment Example
Say you purchased 100 shares of a stock for $50 per share, meaning your cost basis is $5,000. Five years later, you sell all the shares at a price of $80 per share, totaling $8,000 in sale proceeds.
Realized Gain:
- Sale proceeds = $8,000
- Less: Cost basis = $5,000
- Realized gain = $8,000 – $5,000 = $3,000
Recognized Gain:
- The entire $3,000 realized gain would be included or “recognized” in taxable income and reported on the tax return for the year of the sale.
- It would also be recognized under GAAP accounting rules and included in net income for the period.
Unless special tax or accounting provisions applied, the realized gain would equal the recognized gain in this example.
Real Estate Example
Now let’s say you purchased a rental property for $200,000. Over the years, you took $15,000 in depreciation deductions on the property. You later sell the property for $250,000.
Realized Gain:
- Sale proceeds = $250,000
- Less: Original cost = $200,000
- Less: Depreciation = $15,000
- Adjusted cost basis = $200,000 – $15,000 = $185,000
- Realized gain = $250,000 – $185,000 = $65,000
Recognized Gain:
- The $65,000 realized gain would be recognized in full for financial statement purposes under GAAP.
- However, for tax purposes, the recognized gain would be lower because the depreciation taken over the years would need to be recaptured at ordinary income tax rates.
- This would result in a lower recognized capital gain for tax, despite the full $65,000 realized gain.
This example demonstrates how realized and recognized gains can differ depending on applicable rules.
How Realized and Recognized Gains Are Taxed
When it comes to taxes, realized and recognized capital gains are treated differently:
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Realized gains – There is no direct tax impact until the gain is recognized. Realized gains are not reported simply from selling an asset.
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Recognized gains – These are the amounts of gains included in taxable income for the year and subject to capital gains tax rates of 0%, 15% or 20% depending on income.
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Short-term capital gains (assets held 1 year or less) are taxed at ordinary income rates.
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Long-term capital gains (assets held over 1 year) receive preferential tax rates.
While a realized gain represents the true economic gain, recognized gains are the amounts that actually get taxed based on capital gain tax rules.
Proper classification and reporting is essential to accurately calculate capital gain taxes owed.
Frequently Asked Questions
Are realized gains taxable?
No, realized gains are not directly taxable. Realized gains only reflect the mathematical calculation of proceeds less cost basis. The realized gain must be recognized as taxable income before any tax is due.
Can you have a realized gain without a recognized gain?
Absolutely. In certain cases, tax rules may allow deferring recognition of a realized capital gain. For example, a 1031 exchange in real estate allows continuing to defer taxes on a property’s realized gains when proceeds are reinvested in a similar property. Until recognition events occur, no tax is due on realized gains.
Can you recognize a gain without realizing it first?
No, you cannot recognize a capital gain for tax or accounting purposes without first realizing the gain through an actual sale or disposition of the asset. Realized gains must occur before recognition is relevant.
Key Takeaways
- Realized gains are total gains earned from selling assets, while recognized gains are the portions of those total gains included in income.
- Recognized gains follow accounting rules and tax code provisions that may differ from pure economic realized gains.
- While most realized gains become fully recognized, there are certain cases where tax rules permit deferring recognition of realized gains.
- You cannot recognize a gain without first realizing it, but you can realize a gain without recognizing it immediately for tax purposes.
- Only recognized gains are included in taxable income and subject to capital gains taxes, not total realized amounts.
Accurately differentiating between realized and recognized capital gains is vital for proper accounting treatment and tax reporting. Keep these key differences and examples in mind next time you calculate gains from the sale of investments or other assets.
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.
