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1031 Tax Deferred Exchange: Realized Gain vs. Recognized Gain

Realized Gain vs. Recongized Gain

Last week, I started a series of blogs on the Internal Revenue Code Section 1031 tax deferred exchange. The blog covered the concept of "like-kind" exchanges and defined the time constraints involved when conducting a 1031 exchange.

Today, we'll explore the difference between "recognized gain" and "realized gain." While they sound a lot alike, knowing the difference can give the real estate investor an interest-free loan from the IRS! Additionally, we will define the concept of "boot." So, what do these three terms mean?

Realized Gain - This is the amount of gain that the investor made during ownership of the property. The owner calculates this by determining the net sales price (sales price of the property less closing costs) and then subtracts the adjusted tax basis of the property (the formula is relatively simple and your accountant can help you with this).

Boot - Any non "like-kind" benefit received by the Seller after the sale. If the Seller receives cash, this is referred to as "cash boot" and is taxable. If the Seller has a mortgage paid or reduced at closing (and does not acquire an equal amount of mortgage on the new property), the Seller is seen to have gained "mortgage boot," and is taxed the same as if he/she received cash. Any other non "like-kind" benefit would be seen as boot as well. For example, if the Seller received a car as part of the trade, the car would be seen as boot and would be taxed, at its value, as a gain.

Recognized Gain - This is the taxable portion of the above "realized gain." Typically, the only taxable portion of realized gain is the boot received after the sale.

So, to summarize, the key to using a 1031 exchange is to take a realized gain and reinvest it into another property. Done correctly, there will be no boot, and therefore no recognized gain to be taxed!

So, when then does the property owner finally pay these taxes? The answer might surprise you.... NEVER is a valid option. So long as the Seller never takes any boot, then no taxes are paid! The Seller can refinance the property to pull cash-out without having to recognize this as boot, so the cycle can continue for the rest of the investors life.

About The Author

As Broker and Co-Owner of Century 21 First Realty, a Tallahassee Real Estate Brokerage business, Joe Manausa utilizes his MBA and 17 years of Tallahassee Real Estate experience in order to help clients with large investment opportunities while also taking the lead in growing the Century 21 First Realty operation. Additionally, he heads an experienced team of fellow West Point and Annapolis Graduates who run Tallahassee Real Estate Holdings and other entrepreneurial ventures. He contributes to a daily Web Blog which focuses on the Tallahassee Real Estate Market, as well as other topics important to Tallahassee, Florida. For more information on Joe and Century 21 First Realty, please visit his company website at www.manausa.com

Posted by Joe Manausa - Tallahassee Real Estate on 10/01/2007 06:06 AM

Comments (20)

1031 exchange, real estate tax benefits

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20 Comments on 1031 Tax Deferred Exchange: Realized Gain vs. Recognized Gain

I guess the short answer is that as long as you are trading up rather than down, there's no federal tax. But what about state or local taxes?

10/01/2007 06:39 AM

by Brian Schulman - Your Lancaster County, PA Real Estate Professional (Coldwell Banker Select Professionals)

Good morning Joe, nice succinct explanation. I really don't want another newspaper subscription, so please advise when you're syndicated?

10/01/2007 07:10 AM

by Kevin J. May Naples, FL Southwest Florida Real Estate (Prudential Florida Realty)

I'm with Karen - but I think we should take you on the road... hold courses - charge a fee... make some $$$!!! Joe, it is very simple the way you explain it. Industry "experts" make it MUCH MORE difficult...

10/01/2007 07:34 AM

by Eva Armstrong - Environmental Visions (Environmental Visions)

Good post Joe. But what happens with taxes when the investor dies and the property goes to his estate?

10/01/2007 02:25 PM

by Larry Wright (nwRealty.Com)

Brian, we don't have local and state taxes in Florida. You would need to check your own state to see if that would be a factor.

10/01/2007 03:48 PM

by Century 21 First Realty

You are too kind Kevin. Thanks for the comment.

10/01/2007 03:48 PM

by Century 21 First Realty

Thanks Eva. I'll try to make the next ones more confusing....

10/01/2007 03:49 PM

by Century 21 First Realty

Larry, I have no idea. But that is the idea right? Die owing taxes! Let them come after me!

10/01/2007 03:50 PM

by Century 21 First Realty

Another great post. Thanks for the contribution to AR.

10/01/2007 08:20 PM

by Nancy Moeller (RE/MAX Real Estate Services)

Thanks Nancy. I'm hoping that we can stimulate a little more on the investor side in Tallahassee with this series of posts regarding the 1031.

10/02/2007 06:08 AM

by Century 21 First Realty

Larry, when a person dies the property is assessed at market value and is passed on with the new basis and no tax consequence on the deferred gain.

That's the beauty of 1031's, you can keep exchanging into bigger and better properties. My plan is to move into my final property and never sell it. By then I will have couple hundred thousand owed on the deferred gain, so I hope to never see that day.

Now AMT is another story. Let's see if we can get Joe to write about that one...

10/02/2007 12:48 PM

by The TaxMan (Self Employed)

Not a chance TaxMan... With a user name like yours, it sounds like it is right up your alley.

10/02/2007 01:06 PM

by Century 21 First Realty

maybe someday.... it's going to take time to write a good post on that one.

10/02/2007 04:27 PM

by The TaxMan (Self Employed)

I'll be waiting...

10/02/2007 05:36 PM

by Century 21 First Realty

So, if I'm reading this right, if I want to keep some money from the sale, I can do a 1031 on the rest?

10/03/2007 07:56 AM

by Samuel

Yes, and only have to pay taxes on the boot (the cash rec'd) and defer the rest.

10/03/2007 08:28 AM

by Century 21 First Realty

The concept is to "swap until you drop." You keep 1031 exchanging until you pass on. Your heirs will inherit the property from you at a "step up in basis." This means that your heirs cost basis becomes the market value of the property at the date of your death.

For example, if I bought property for $100,000 and it is worth $1,000,000 today and I died today, my heirs would inherit the property today and their cost basis becomes $1,000,000 because that is the market value of the property on my date of death. They could sell the property for $1M and pay no taxes. They are only responsible for any gain or growth in value above $1M.

There are still inheritance (estate) taxes to worry about.

11/30/2007 05:16 PM

by Bill Exeter (1031 Exchange Expert) (Exeter 1031 Exchange Services, LLC)

Why is it that in a sale only the realized gain gets taxed (capital gains) whereas in a partial exchange the boot gets taxed regardless of the net gain. Give you an example: I bought a proprty for $1,000,000 (all cash) four years ago. Today it is worth $1,500,000. Say I want to pull $500,000 for other purposes. If I only reinvested $1,000,000 I would have pay capital gains tax on the boot of $500K, with all the restrictions of the 1031 exchange. On the other hand if I didn't do an exchange, I would still be paying tax on the realized gain of $500K but now don't have to worry about the restrcitions of the 1031. So what is the advantage of exchange? Am I missing something?

05/10/2008 05:06 PM

by Ram

Hey Ram,

Boot is always taxable, as it is gain that is realized. Why not just refi the property (don't do a 1031) or do a 1031 and after closing put a 2nd mortgage on the property? Loan proceeds are not boot and are therefore not taxable.

05/12/2008 01:07 PM

by Century 21 First Realty

Joe:

Good post. Just a reminder to your readers that in order to have a valid 1031 exchange and defer the realized capital gain so that it is "not recognized," they will need to use a reputable qualified intermediary to avoid actual and/or constructive receipt.

Regarding Ram's question and you answer: Be very careful about the refi option. If you plan to refi (check with your accountant), it is better to refi after the purchase of replacement property because if you refi the relinquished property prior to selling, the "cash out" will most likely be considered boot and taxed. This is a sensitive area, Ram and you should not make a decision without discussing all of the consequences with your accountant.

Lisa

05/12/2008 01:38 PM

by Lisa Lambert, Esq. (1031 Exchange Expert) (1031 Exchanges - Asset Preservation, Inc.)

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