 Hello and welcome to this session in which we will discuss the concepts of gains and losses in property transaction. Specifically we're going to be focusing on one aspect of this and this is called the amount realized. So whether you are a CPA candidate or an enrolled agent or an accounting student taking a tax course, the concept of gains and losses is extremely important in property transaction. So when you sell a property well you might have either a gain or a loss as a result of this transaction and it's very important that you distinguish between the realized gain and loss and the recognized gain and loss from this property. So we're going to have some of it will be realized and some of it will be realized and recognized. Well what happened if it's not realized and recognized it will be deferred. So the gain slash loss realized represent the amount actually realized. It means what actually happened. What's the actual gain or the actual loss. Now sometime this gain or loss may be recognized and what is recognized it means recorded. It means if it's a gain it's going to increase your taxable income. If it's a loss it's going to be a deduction. However the gain slash loss recognize indicate the amount that should be reported on the taxpayer tax return. As I just said if it's a gain it's going to increase your tax taxable income. If it's a loss it's going to deduct. To determine the gain and the loss we should first calculate something called the amount realized from a given transaction. So we're going to be focusing on this concept. What is amount realized because once you know what's the amount realized from that you can generate whether you have a gain or a loss. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead start your free trial today. No obligation, no credit card required. So let's focus on the term amount realized. A taxpayer may dispose at means sell of a property through sale, trade and transaction, casualties, condemnation, theft, bond retirement and so on and so forth. This is when you get rid of something, when you dispose of something. The amount realized, the amount that you receive from the disposition should equal to the total consideration received in the exchange. So if you gave up something you're going to be receiving consideration in return. Well that consideration minus expenses you incur equal to the net sales, whatever you received in net sales. Now the consideration might include cash, usually it includes cash when you sell something you would receive cash. Also mortgage or loan transferred to the buyer. So if you have a piece of property and there's a mortgage against that asset and you transfer the asset and the mortgage simply put if you get rid of the mortgage, if the buyer assumes the mortgage, it's more money to you because you no longer have to pay this mortgage. They are responsible for paying the mortgage, the buyer. If you received any fair value of any services, well that's consideration to you. Fair market value of any property received. If the buyer pays any taxes on that property, all of those are consideration received which are included in the amount realized. Therefore let's take a look at the complete formula. Well, fair value of property received. So amount realized would include the fair value of any property received plus the fair value of any services received. Of course that's to you. Any taxes paid by the buyer on your behalf. Obviously the cash received. Basically the cash, I should have listed the cash first because that's the most important one. So those all going to increase your amount realized. Then if you paid any cash, it's going to reduce if you paid for any expenses. If there is any debt relief, debt relief means you no longer responsible for the debt. That's positive to you. That's amount realized. If you take over that, if you assume that as a result of this transaction, now you deduct it from the proceeds. If you assume that but if the debt is relieved, you are no longer responsible as if they pay for it minus any selling expenses and that's going to give you net amount realized. Now bear in mind the fair market value of any asset represent the value of that asset determined in an arm length transaction. What is that arm length transaction that's in contrast to related party arm length is when the transaction entered between two willing buyer and seller and neither is obligated to enter into this transaction in contrast to a related party transaction where the buyer and the seller can influence each other can dictate something other than fair market value of the transaction. Just keep that in mind. We'll talk about related party transaction later on. Let's take a look at an example. Bob sold Calvin a parcel of land under the sale contract. The two parties agreed to the following. Bob to receive 71,000 in cash and a note receivable in three years for 30,000. Calvin assumes Bob's mortgage. So Calvin took Calvin says, okay, don't worry, there's a mortgage of 7,000. I will assume that Calvin pays the realtor 6,500 on behalf of Bob. Calvin pays the entire annual property taxes of 5,000. Although Calvin's share is limited to 3,200, but he paid the whole thing. Bob pays a legal fees of 6,20. Calvin pays legal fees of 9,20. What we're going to do, we're going to determine how each item listed above affect the amount realized by Bob from the sale of the transaction in the adjusted basis in the property that Kevin acquired. Starting with Bob, the cash and the notes receivable received by Bob, which is the 71,000 and the 30,000. And the mortgage assumed by Calvin. Remember, Calvin assumed the mortgage of 7,000 as well as the realtor commission paid by Calvin also paid it on your behalf, 6.5,000, 6,500, would increase the amount realized by Bob. At the same time, it increases Calvin's basis because this is what Calvin paid for, the 71 plus 30 plus 7 plus 6,500. The share of property taxes paid by Calvin on behalf of Bob, which is 1,800, because Calvin's share, only 3,200, would also increase the amount of realized by Bob. So we're going to have to add this 1,800 and Calvin basis in the property. The remaining property taxes will simply be deducted on Calvin's schedule A as itemized deduction. As far as for the legal fees, the amount paid by Calvin would increase his adjusted basis, which was 950 in the acquired property. Well, the amount paid by Bob would decrease the amount realized. Basically, this is legal fees. It's a minus. It's basically think of it as a selling expense. In cases where the sale of property occurred during a given tax year and the buyer pays the tax associated with that property for the entire year, the deduction of taxes is allocated in between the buyer and the seller based on the ownership period. And we would look at an example to illustrate this concept. Maggie sold a property to Sarah on March 9th, 2004 for 600,000. In addition, Sarah and Maggie agreed that Sarah would pay the annual real property taxes of 10,000 on October 1st of 2021. Well, determine the amount of property taxes that might be deducted by each Maggie and Sarah. Well, let's see. It's going to be prorated. Sarah paid the property taxes for the entire year. However, she's allowed to deduct on her income tax return the portion equivalent to her ownership period only, which goes from March when she purchased the property till December 31st. On the other hand, Maggie is allowed to deduct the remaining taxes on her income tax return. As such, the amount, let's look at the amount. We're going to prorate it. We're going to go 298 days divided by 365. This is the prorated amount multiplied by $10,000, which is 8,164. This is the amount here, 8,164. So basically what we did is we prorated the amount. Now the amount of taxes to be deducted by Maggie equal to this portion here, which is 65 days divided by 365 times the full amount, which is 1,836. So what they did is they prorated the amount based on their ownership period. How does the property tax apportionment affect each of Sarah's basis and the property? Well, Sarah paid Maggie 1,000 property taxes of 1,836. Therefore Sarah's basis on the property will equal to the amount that she paid plus, and she also paid in addition 1,836. It would be 601,836. It's also important to note that the remaining taxes paid by Sarah would be deductible on Schedule A. It's itemized deduction. However, the extra 1,836 increased her basis, and the other taxes will not affect the basis because she's supposed to pay those taxes. It's not part of the basis. Think of it as part of her annual tax expense. How does the property affect the amount realized by Maggie for the sale of the property? Well, the amount realized by Maggie would equal to the amount collected $600,000 plus the amount taxes paid on her behalf. Therefore, it's going to be $600,000 plus the 1,836. That's the amount realized by Maggie because she's supposed to pay the 1,836. Somebody paid it on her behalf. It's amount realized to her. Let's take a look at another scenario. Assume that property taxes were paid by Maggie. Now, Maggie paid them. Well, if Maggie paid the property taxes, her realized amount will equal to $600,000 minus the property taxes that she paid on behalf of Sarah, which was computed above $8,164,000 and Maggie's realized will be $591,836 because she paid the taxes on Sarah's behalf. In parallel also, Sarah's basis will be what she paid minus what Maggie's paid on her behalf, which will be lower $5,198,836. Now, let's talk about realized gain or loss. What is realized after we determine the amount realized? What we're going to do from that transaction will take the amount realized minus the cost and that's going to give us the realized gain or loss, which is the difference between the amount realized minus the cost. So, amount realized, which we were talking about, minus the cost will give us the realized either gain or loss. The calculation is summarized in this formula. Let me show you. Amount realized, which we talked about earlier up to this point, minus the adjusted basis of the property, which is the initial basis plus capital addition minus any cost recoveries, which is the appreciation and other capital deduction we spoke about in the prior session, which will give us the amount realized of gain or loss. Remember, although the amount realized, it doesn't mean it's taxable, nor it may not be deductible as well. We have to find out because that's the recognized part. Let's take a look at a few examples. Aiden sold equipment used in his business to Alvin for $40,000. He received $20,000 in cash and a property of a fair market value of $20,000. That's $40,000 in total. At the time of the sale, Aiden's equipment had an adjusted basis of $31,000. So, the amount realized is $40,000, adjusted basis is $31,000. You got it. We have a realized gain of $9,000, which is $40,000 in amount realized minus the cost basis. Example two, Angelo owns a building that's subject to a mortgage of $15,000. The building is sold to Larisa for $45,000 in cash. In addition, Larisa assumes the mortgage attached to the building. So, what happened is Angelo received $45,000. In addition to the $45,000, since Angelo is no longer for the mortgage, Angelo received in total $60,000. That's the total amount received by Angelo. So, the total amount realized by Angelo is $60,000. Now, we would compare this to the basis. We'll determine the realized gain or loss. Let's take a look at this example. On December 13, 2020, X3, Caroline sold an office building to Mark under a sale contract sign on the same date. The two parties agreed to the following. Caroline pays Mark cost of obtaining credit of $12,200. Sometimes that's the case. They have a cost to obtain the loan. Caroline said, you know what? No worries. I would help you with that because she wants to sell the building. So, she's trying to facilitate the process, $12,200. Mark pays $5,050 to Caroline in cash. That's the price that Mark is going to pay. Mark assumes her mortgage for $150. And if Mark assumes her mortgage, as if Mark paid an additional $150 to Caroline. In addition, there's the brokerage commission cost amount of $33,000. Determine the amount realized by Caroline from the sale of the transaction? Well, let's take a look. The amount of realized is $654,800. Let's see how it's computed. Amount of cash, that's pretty straightforward. Mortgage assumed by Mark, $150. The brokerage fee, $33,000 because the brokerage fee is paid by Caroline. We assume it's paid by Caroline. Caroline paid this. So, that's basically part of the selling expenses. Then she also paid the cost. Remember, she paid on behalf of Mark the cost to obtain the credit, $12,200. So, if you take all of those, you net them, should be $644,800, the amount realized. Now, we compare this to the cost, then we'll determine the gain or the loss. Now, recognized gain or loss? Again, what is recognized? It's mean that's the amount that's going to be listed. That's going to be listed on the tax return. So, if it's a gain, it's going to increase our taxable income. If it's a loss, great. It's a deduction. We like losses for tax purposes. The recognition of a realized gain indicate that the gain is taxable. A recognized gain is included in the tax returns gross income. In contrast, a realized loss indicate a tax deduction. It gets deducted, and it's reduced your gross income, which we like this. Again, we like this for tax purposes. Realized gain and losses are not always recognized. What happened if they're not recognized? They might be deferred. In some cases, realized gain or loss are simply deferred. It means we push them down the road at a later date, which result in a temporary non-recognition of a gain or a loss. And we'll see later on under what circumstances we do that. Later on means not long, not long from now. In other cases, realized gain may be non-taxable, and realized loss may be disallowed, which result in a permanent non-recognition of a gain or a loss. Sometimes the gain is never taxable, and the loss is never deductible. An example of disallowed loss is the loss on a personal use property. You don't, you cannot deduct personal use property. Don't confuse personal property with personal use property. For example, your personal car. If you sell it, you incur the loss. You don't deduct it. If you sell your furniture and incur a loss, you don't deduct it. The determination of recognized gain or loss is summarized in the following chart. So this is what we did up to this point. We started by looking at the amount realized, and we learned how to compute this amount, the consideration received, right? Then we take the consideration received and we deduct the adjusted basis from it. At this point, we either have a realized gain or a realized loss. Nor is realized and realized. It's either a gain or a loss. Now, if we have a gain, then we, we might have to defer some gain, which is non-taxable. And after we defer the gain, what's left is recognized. It means the taxable portion. Same thing with the loss. After we determine the loss, some of the loss might be disallowed or deferred, means deferred for later. And we're going to see later on what does it mean, deferred specifically. And whatever's left is the deductible amount, the amount that we like to have on the tax return. What should you do now? You should go to Farhat Lectures and look at MCQs. Look at additional resources that's going to help you in understanding this concept. Property transaction amount realized, deferred gained, deferred losses, those are extremely important concept that you need to have, you need to be aware of them inside out. Farhat Lectures is here to always help you. Good luck. Study hard. The CPA exam is worth it. And of course, stay safe.