DEFINITION of Amount Recognized
Amount recognized, for tax purposes, is taxable income you receive or deductible loss you incur that must be reported on your tax return and on which you must pay tax.
BREAKING DOWN Amount Recognized
When you sell your property, the amount realized is the sales price you receive less selling costs you paid; and the amount recognized is the amount realized minus your adjusted basis in the property. You adjusted basis is the original purchase price plus the costs of any improvements you made. The amount realized when you render services is the compensation you receive for your services less the marketing expenses you incurred to land the client. The amount recognized is the amount realized minus business costs incurred to render the services.
Amount Recognized for Tax Purposes
Amount recognized for tax purposes is determined by the Internal Revenue Code (IRC). Suppose you bought a 1959 Gibson Les Paul Standard guitar for $50,000, spent $10,000 refurbishing it and paid $2,000 in commissions and fees to sell it at auction for $100,000. The $100,000 you receive from the sale is your sales proceeds. The $100,000 sales proceeds less the $2,000 costs you incurred to sell the guitar is your amount realized. Your $98,000 amount realized less your $50,000 cost basis adjusted by $10,000 of improvements is your $38,000 amount recognized. $38,000 amount recognized is the gain you will use to determine the amount of tax you owe on the sale. You do so by multiplying $38,000 amount recognized by your capital gains rate. Assuming your long-term capital gains rate is a flat 20%, the tax you owe is $7,600.
Non-Recognition of Amount Realized
The IRC determines if and how much you recognize as taxable income or deductible loss. Sections of the IRC known as “non-recognition provisions” exempt selected income or loss from recognition. A well-known example is gain from tax-exempt bonds. Non-recognition provisions also exempt selected transactions from recognition. A well-known example is the sale of your principal residence. Here’s how it works. Suppose, after subtracting selling expenses, you realize $1,000,000 from the sale of a home. If you bought the home for $300,000, you must recognize a $700,000 capital gain. However, if the home you sold was your principal residence, the home sale gain exclusion exempts up to $250,000 of the gain if you are single and up to $500,000 of the gain if you are married. The exclusion reduces your amount recognized from $700,000 to $450,000 if you are single and to $200,000 if you are married.
Deferral of Amount Recognized
The IRC also determines when an amount is recognized. Sections of the IRC known as “deferral provisions” postpone recognition of gain to a later time. Deferral is accomplished by adding the gain from the property you sold to the basis of the property you acquired. This way, tax liability for the gain is deferred until the property is later disposed of in a taxable sale. Let’s say you transfer rental property worth $600,000 and, in exchange, you receive rental property worth $500,000 and a realized gain of $100,000. This is a like-kind exchange. A deferral provision postpones the recognition of your realized gain. The $100,000 realized gain is added to the basis of the rental property you acquired in the exchange. The gain will not be recognized until you later dispose of the rental property in a taxable sale. Another deferral provision known as “involuntary conversion” allows you to postpone recognition of gain realized from insurance proceeds that exceed the value of property you lost in a fire or flood as long as you use the insurance proceeds to buy replacement property.
The realized gain is added to the basis of the replacement property and is not recognized until you later dispose of the replacement property in a taxable sale.
Amount Recognized for Financial Reporting Purposes under GAAP
So far, this article has focused on amount recognized for tax purposes under the IRC. However, amounts are also recognized for financial reporting purposes in accordance with generally accepted accounting principles (GAAP). The amount recognized for tax purposes is likely to be different than it is for financial reporting purposes because the IRC and GAAP use different accounting methods to determine it. The IRC, using cash accounting, recognizes amounts as income when they are received and as expenses when they are paid. GAAP, using accrual accounting, recognizes amounts as income when they are earned and as expenses when they are incurred. This means the IRC and GAAP will recognize the same amounts at different times. For example, assume a company makes two sales. In the first sale, the customer pays $80 for goods in December 2017 and the Company delivers the goods in February 2018. In the second sale, the Company delivers goods on credit in December 2017 and the customer pays $100 for them in February 2018.
For cash accounting and tax purposes, the amount recognized is $80 paid in December on the first sale and $100 paid in February on the second sale. For accrual accounting and financial reporting purposes, the amount recognized is $100 earned in December on the second sale and $80 earned in February on the first sale.
Temporary and Permanent Differences in Amount Recognized
The example above shows you how the timing of recognition can differ between the two methods. Sometimes these differences are permanent and sometimes they are temporary. In the example above, the differences are temporary since, by February 2018, both methods have recognized $180 for the two sales. However, in 2017, $80 for the first sale and $0 for the second sale was recognized as taxable income on the company’s 2017 tax return while $0 was recognized for the first sale and $100 was recognized for the second sale on the company’s 2017 financial statements. Reconciling temporary differences requires complicated accounting adjustments under GAAP. These adjustments are known as inter-period income tax allocations and the temporary differences described are reported on the company’s financial statement as deferred income tax assets or deferred income tax liabilities.