Realized vs Recognized Gain in a 1031 Exchange

Realized gain is the economic profit on your sale: what you received, less your adjusted basis. Recognized gain is the portion of that profit you report and pay tax on this year. In a fully deferred 1031 exchange you can have a large realized gain and a recognized gain of zero. When you receive boot, such as leftover cash or a net reduction in debt, you generally recognize gain up to the amount of that boot, but never more than the gain you actually realized. The difference between the two numbers is the gain you have deferred.

Why do these two terms matter?

They show up on Form 8824, in your CPA's workpapers and in conversations with your Qualified Intermediary, and they are easy to mix up. Owners often hear that a 1031 exchange "avoids" tax on the gain. It does not. It moves the realized gain out of this year's return and into the basis of the property you buy. Knowing which figure is which helps you read your own closing numbers and ask better questions before you sign anything.

How do you calculate realized gain?

Realized gain starts with the amount realized on the sale. That is broadly the sale price, less qualifying selling costs such as broker commissions and certain closing costs. From that you subtract your adjusted basis, which is generally what you paid for the property, plus capital improvements, less the depreciation you have claimed over the years.

Two points catch people out. First, paying off your mortgage at closing does not reduce the amount realized. The debt relief is counted as part of what you received. Second, depreciation lowers your basis, so an owner who has held a rental for a long time can have a realized gain far larger than the appreciation they think of as their profit.

How do you calculate recognized gain?

In an exchange, recognized gain is generally the lesser of two numbers:

• ›The gain you realized on the sale
• ›The boot you received, after the netting rules are applied

Boot is anything you receive that is not like kind real property. The common forms are cash left over with the intermediary at the end of the exchange, cash paid to you at closing, and a net reduction in mortgage debt that you did not offset with new debt or added cash. Certain closing costs paid from exchange funds can also count, which is why settlement statements deserve a careful read.

If you receive no boot, recognized gain is zero. If boot exceeds your realized gain, you recognize only the realized gain, because you cannot be taxed on more profit than you made.

What does a worked example look like?

The figures below are illustrative only. They are simplified, ignore purchase side closing costs and state taxes, and are not a projection of any result.

Suppose an owner sells a rental for 1,000,000 dollars and pays 60,000 dollars in selling costs. The adjusted basis, after years of depreciation, is 400,000 dollars. A 300,000 dollar mortgage is paid off at closing, and the remaining 640,000 dollars goes to the Qualified Intermediary.

• ›Amount realized: 1,000,000 less 60,000, which is 940,000 dollars
• ›Realized gain: 940,000 less 400,000, which is 540,000 dollars

The owner then buys a replacement property for 900,000 dollars, using 600,000 dollars of exchange funds and a new 300,000 dollar loan. The intermediary returns the unused 40,000 dollars after the exchange ends.

• ›Mortgage boot: none, because 300,000 dollars of old debt was replaced with 300,000 dollars of new debt
• ›Cash boot: 40,000 dollars
• ›Recognized gain: the lesser of 540,000 and 40,000, which is 40,000 dollars
• ›Deferred gain: 540,000 less 40,000, which is 500,000 dollars

The basis of the replacement property in this example is its 900,000 dollar cost less the 500,000 dollar deferred gain, or 400,000 dollars. The deferred gain has not disappeared. It sits inside the lower basis and may be recognized when the replacement property is eventually sold in a taxable sale.

Can recognized gain ever be larger than the boot?

Not under the basic exchange calculation, but the character of the gain can make a small number feel larger. Recognized gain on a rental may be treated first as depreciation related gain, which can be taxed at a different federal rate from ordinary long term capital gain, and it may also attract the net investment income tax and state income tax. Your CPA can tell you how your recognized gain is likely to be characterised.

What if the boot is bigger than the gain?

Take a different illustrative case. An owner sells for 500,000 dollars, has 30,000 dollars of selling costs and an adjusted basis of 420,000 dollars. The realized gain is 50,000 dollars. If the owner trades down and keeps 80,000 dollars of cash, recognized gain is capped at the 50,000 dollar realized gain. The remaining 30,000 dollars of cash is a return of the owner's own basis, which generally reduces the basis carried into the replacement property.

What happens if you realize a loss?

Section 1031 does not let you recognize a loss on the exchanged property either. If your adjusted basis is higher than the amount realized, the loss is generally deferred in the same way a gain would be, and carried into the basis of the replacement property. Owners selling at a loss sometimes prefer a taxable sale so they can use the loss now. That is a question for your CPA before you engage an intermediary, because the decision is hard to unwind after closing.

How do realized and recognized gain affect your next exchange?

Every exchange carries the deferred gain forward into a lower basis. If you exchange again later, the realized gain on that next sale will usually include the gain deferred this time, plus any further appreciation and depreciation. That is why owners who exchange several times can end up with a very large realized gain on paper and a small basis. Some hold until death, when heirs may receive a stepped up basis under current law, while others plan for a taxable sale. Rules can change, and the right path depends on your circumstances.

Questions to bring to your CPA

• ›What is my adjusted basis, including improvements and depreciation claimed?
• ›Which selling costs reduce my amount realized, and which could be treated as boot if paid from exchange funds?
• ›Will my debt on the replacement be equal to or greater than the debt paid off?
• ›How would any recognized gain be characterised, and in which tax year would it fall?
• ›What will the basis of my replacement property be, and how will it be depreciated?

The short version

Realized gain is what you made. Recognized gain is what you are taxed on now. A well structured 1031 exchange keeps the second number as low as the rules allow, while the first is carried forward in your basis. Run your own figures with your CPA and Qualified Intermediary before you sell, because the numbers that matter are fixed at closing.