1031 Tax Deferred Exchange: Realized Gain vs. Recognized Gain

By
Real Estate Agent with Century 21 Manausa and Associates BK3009719
http://actvra.in/HfN

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


 

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Joe Manausa, MBA, CRB, CRS | Broker / Owner | Century 21 First Realty

2365 Centerville Road | Tallahassee, Florida 32308 | (850) 386-2001 | http://www.manausa.com

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Joe Manausa, MBA
Century 21 Manausa & Associates

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Anonymous #18
Anonymous
Ram

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?

May 10, 2008 05:06 PM
Rainmaker
740,915
Joe Manausa
Tallahassee Real Estate
Century 21 Manausa and Associates

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.

May 12, 2008 01:07 PM
Rainer
60,772
Lisa Lambert
Esq. 1031 Exchange Expert
The Law Offices of Elisabeth A. Lambert

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

May 12, 2008 01:38 PM
Anonymous #21
Anonymous
Joe

If one does a 1031 exchange on rental property and then later (say after 2 years) lives in the property for at least 2 years can they sell it and take addvantage of the $500,000 exclusion? 

November 05, 2012 02:30 PM
Rainmaker
740,915
Joe Manausa
Tallahassee Real Estate
Century 21 Manausa and Associates

Great question for your CPA Joe, and one I cannot answer. Were I to guess ... I would say "no way."

November 06, 2012 02:22 AM
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Rainmaker
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