Legal Definitions - Realization of gain

Realization of gain refers to the specific moment when an asset is sold or exchanged for a value that is greater than its adjusted cost basis. The adjusted cost basis is generally the original purchase price of the asset, plus any costs incurred to improve it, and minus any depreciation that may have been taken over time. The "amount realized" from a sale includes all money received plus the fair market value of any other property or services received in exchange for the asset.

When the "amount realized" from a transaction exceeds the asset's adjusted cost basis, a gain has been "realized." This term specifically refers to the event of the transaction itself, where the increase in value becomes concrete through a sale or exchange. It's important to understand that realizing a gain is not always the same as "recognizing" a gain for tax purposes; some realized gains may be exempt from immediate taxation due to specific legal provisions or deferral strategies.

Here are a few examples to illustrate the concept of realization of gain:

• Selling Investment Stocks: Imagine an investor purchased 100 shares of a technology company for a total of $5,000. Five years later, the investor sells all 100 shares for $8,500. The adjusted cost basis for the shares was $5,000, and the "amount realized" from the sale was $8,500.

  In this scenario, the investor has a realized gain of $3,500 ($8,500 - $5,000). This gain is realized at the moment the stock transaction is completed, as the asset was converted into cash at a higher value than its cost.

• Selling a Rental Property: A property owner bought a small rental house for $250,000. Over the years, they invested $30,000 in significant renovations, bringing their total investment to $280,000. After accounting for depreciation deductions taken over the years, their adjusted cost basis for the property is $220,000. They then sell the rental house for $350,000.

  Here, the "amount realized" is $350,000, and the adjusted cost basis is $220,000. The owner has a realized gain of $130,000 ($350,000 - $220,000) from the sale of the property. The gain is realized because the property was sold for more than its adjusted cost.

• Exchanging a Collectible Item: A collector purchased a rare vintage watch for $1,500. Years later, they decide to trade it with another collector for a different rare watch that has a current market value of $4,000, and they also receive $500 in cash as part of the exchange.

  The adjusted cost basis of the original watch was $1,500. The "amount realized" from the exchange is the sum of the cash received ($500) and the fair market value of the new watch ($4,000), totaling $4,500. Therefore, the collector has a realized gain of $3,000 ($4,500 - $1,500) from this transaction. The gain is realized because the original watch was exchanged for other assets (cash and another watch) with a combined value exceeding its cost.