Realized vs Recognized Gain in 1031 Exchange

When it comes to getting a considerable amount of passive income, investing in real estate property usually comes into mind. To take most of it, investing in 1031 exchange properties can come along with numerous benefits. In fact, selling properties under the 1031 Revenue Code Rules can defer capital gain taxes. To better understand the 1031 exchange concept and how realized and recognized gain works within it, we recommend attentively reading this article.

What is realized gain?

Before getting into detail about the 1031 property exchange and how investors can benefit from that, let’s have a close look at how the realized gain is formed. In a standard case, when the owner decides to sell the property, he is expecting some gain from it. This is called the realized gain – the profit obtained as the result of the sale transaction.

The amount of money considered to be a realized gain is calculated using a simple formula. Basically, this is the difference between the net sale price and the adjusted tax basis.

To calculate the tax basis, it is necessary to add adjustment costs for capital improvements to the original purchase price of the property. Then subtract any depreciation costs for the previous tax years.

In simple words, the realized gain is the difference between the net sale price and the initial property costs together with the repair-associated investments. In case there are depreciation costs for the prior taxation period, they should be appended.

What is recognized gain?

The recognized gain can be calculated as the difference between the net selling price and the initial cost of the property. It is also known as the taxable amount of the realized gain. The realized and recognized gain might seem similar at first, but those are different when it comes to taxation.

In fact, the recognized gain is the basis for taxation after the sales transaction is complete. However, under the 1031 property exchange regulation, property sellers can be deferred from capital gain tax and obtain outstanding reinvestment opportunities.

What is 1031 Property Exchange?

This is a broad concept that includes plenty of rules of how the real estate properties could be exchanged in order to defer the capital gain tax. Its name comes from Section 1031 in the Internal Revenue Service Code that has regulations on tax deferral in case of property exchange.

When performing an exchange under the 1031 Section of the Revenue Code, there are some requirements for the real estate property types. The current property the investor is planning to sell should be similar to the real estate property for purchase. Moreover, the latter should be of the same or greater price than the currently owned property.

How to defer capital gain tax under 1031 exchange?

Following certain rules mentioned in the 1031 Revenue Code Section allows getting tax deferral when selling a property. However, everything is not that simple as it might seem as there are lots of nuances and details that property owners should be aware of.

Exchange property types

The main requirement for the exchange is that the property for purchase should be likewise the property for sales. It does not necessarily mean that all the parameters of the current and future property should perfectly match though. Also, investors should keep in mind that future real estate objects should not be acquired for personal use.

Within the exchange procedure, real estate properties could be practically swapped under certain regulations. For instance, an apartment could be substituted by an office building or another apartment. Alternatively, the vacant land plot can be also considered for the bargain.

Previously, it was possible to exchange a real estate property on objects other than buildings and offices. However, several years ago, certain regulations were introduced in order to ban the exchange of real estate property for personal and intangible ownership. Thus, purchasing pieces of artwork or patents after buying real estate property does not guarantee tax deferral for investors.

Timing

Before you decide to sell your real estate property, you need to be aware of the important time stamps. Following them is crucial in order to defer capital gain taxation and reinvest in other properties.

The 1031 Revenue Code Section states that the property purchase must be identified within 45 days after the sales process is completed. However, there is no need to wait until the bargain is finalized as you can search for the potential properties for purchase even before selling the current one.

When all the preparation steps are done and the property for purchase is selected, investors have 180 days to conclude the exchange. In this case, the help of experienced real estate brokers or intermediaries would be needed to finalize the deal and get all the required documentation on time.

Sales process

Once the real estate property is sold, the realized and recognized gain is usually calculated. The latter one is particularly important as it defines the taxable portion of income obtained from sales. Under the 1031 exchange regulations, those concepts do not mean much as tax could be deferred. However, the help of a qualified and reliable intermediary would be essential in this case.

When making sales within the 1031 exchange, an investor is not expected to get cash. Otherwise, that would be considered as traditional sales and all the taxation rules would be applied as usual. Instead, an intermediary would be the responsible person who holds money in between the sales and purchase bargains. Once the property for purchase is identified, an intermediary would transfer them to the seller.

What are the benefits of investing in 1031 exchange properties?

The most obvious benefit of the 1031 property exchange is that investors could avoid paying thousand-dollar taxes. However, it is very important to follow all the rules properly and adhere to the regulations.

While the process of 1031 property exchange might seem complicated, investors obtain a unique opportunity for tax-free reinvestment. In the long perspective, investors could accumulate more assets and ensure capital growth over years.