In this video, and the next series of videos, we'll be looking at how to calculate the gain and loss on the disposition or exchange of an asset. At a very high level, it's important to be able to calculate the gain or loss upon selling or exchanging an asset. Because, of course, gains are taxable and losses are deductible. That is, these kinds of property transactions will affect a business owners tax liability. So, in general, how do we figure out the gain or loss on the sale, disposition or exchange of an asset? First, we start with the amount realized. This is basically what the seller receives upon giving up the asset. Then, we subtract out the adjusted basis of that asset. That is, the tax basis or the net book value of the asset on our balance sheet. The difference between the amount realized and the adjusted basis will give us the realize gain or loss. We can think of this as the economic gain or loss. On net, what did I get in? In very simple terms, if I got more than what I gave up, it's a realized gain. If I gave up more than I got, I have a realized loss. Now, thinking way back many, many videos ago, there could be a difference between the realized gain or loss, or economic gain or loss, and the recognized gain or loss. Or the gain or loss that actually gets reported on the tax return. The differences here could be due to postponed or deferred gains or losses. That is, for example, although the gain might be realized in the transaction, maybe I don't have to report it on my tax return until some point in the future. This is a postponed or a deferred game. Another difference between realized and recognized gains or losses is that the gain may be entirely tax-free. Or the loss maybe disallow, that is, not deductible ever. These items are more permanent compared to postponed or deferred gains or losses which are temporary since they will be recognized at some point in the future. In contrast, tax-free gains and disallowed losses will never be recognized. Overall, the gain or loss can be either capital in character or ordinary in character. Recall, that for individuals and sole proprietor businesses, capital gains receive preferential tax rates while ordinary gains are taxed at the top applicable marginal tax rates. We'll look at character in a later module. For now, we need to be able to navigate through this formula in order to figure out the correct gain or loss amount to begin with. To start, let's look at the amount realized. The definition of amount realized is basically everything of value received from the buyer of the asset minus selling costs to get the assets sold. In plain terms, the amount realized is what the taxpayer got in this transaction. But what's included in this amount exactly? Well, the amount realized equals the cash received in the transaction plus the fair market value of any other property that was received in the transaction. This could include a variety of other items. For example, if the seller doesn't get cash today, but rather a note receivable, that is, a promise to be paid in cash in the future from the buyer, then the seller still get something of value. The amount realized goes up. What's also a value is if the seller actually disposes of a liability that is attached to the sold property and if the liability is assumed by the buyer. That is, it's not that the buyer is paying the seller cash. It's that the buyer is taking on a liability that the seller had but now the seller doesn't need to pay back. This is value to the seller and is, basically, equivalent to getting the cash from the buyer and paying off the debt. So if a buyer assumes the sellers liability, the seller increases the amount he or she realizes in this transaction. The sellers economic income goes up because the liability is now gone. Similarly, if there are any property taxes on the property that the seller owed but that the buyer will pay, this will also increase the amount realized to the seller. Again, this is a cost of the seller should be paying but the buyer is paying it on the seller's behalf. This creates value to the seller and, thus, would increase the sellers amount realized. Finally, we can reduce the amount realized by any reasonable expenses related to getting the property sold. For example, expenses related to advertising, or commissions, or legal fees to drop the sales contract will all reduce the amount realized. Let's look at an example, here. 6 years ago, Ted purchased 100 acres of land for $100,000. This year, Ted sold the land to build. The property contract revealed the following. Cash received by Ted of $275,500. Sales commission paid by Ted a $40,000. Taxes owed by Ted, but paid by Bill for $3,000. Lawyer fees related to the contract for $1,500. Ted's bank loan, assumed by Bill for $80,000. Note receivable for Ted in the amount of $10,000. And fair market value of other property received by Ted for $15,000. What is the amount realized and the gain or loss from Ted's sale of the land to Bill? First, we need to look at each of these items and asked whether or not they increase or decrease Ted's economic income. Or show any increase or decrease in the value that Ted experienced as a result of the transaction. So first, Ted receives cash of $275,500. Clearly, this will increase Ted's wealth. So it increases his amount realized. However, Ted has to pay a sales commission to get the land sold. This $40,000 paid will decrease Ted's amount realized. Next, Ted owed some taxes on the land but Bill said he would pay for them. Does this increase or decrease Ted's amount realized? Well, here it increases Ted's amount realized. Ted is getting something a value because Bill will pay Ted's tax bill. What about the lawyer fees paid by Ted? As a selling expense, this will decrease Ted's amount realized. Ted also has a bank loan on the property, but this liability is assumed by Bill. That, is Bill says he will pay the loan and Ted doesn't have to anymore. Does this reduction in debt increase or decrease Ted's amount realized? Well, this will increase Ted's amount realize because Ted just got rid of a liability. Getting rid of a liability has value, it increases Ted's wealth. Next, Ted will get a note receivable from Bill. That is, Bill won't pay Ted the $80,000 in cash today, but rather over the next several years. This is still value to Ted. And so, it will increase his amount realized. Finally, Ted receives other property from Bill with a fair market value of $15,000. Receiving additional property will also increase Ted's amount realized. He is getting something of value in exchange for the land he's giving up. So in all, the effects of the items on the amount realized are listed here. The positive signs indicate an increase in the amount realized, while the negative signs indicate a decrease in the amount realized. We have a total amount realized of $342,000. So what do we do with this $342,000 amount realized? Is this actually Ted's gain or loss? Well, it's actually not his gain or loss. We need to compare this amount realized to the bases Ted has in the land he just sold. Recall from many videos ago, the capital recovery doctrine. Taxpayers are not taxed when they simply recover their invested capital. Here, Ted invested $100,000 in the land. So getting that $100,000 back is not taxable. Thus, will reduce the amount realized by the basis in the land in order to calculate the gain or loss. After we reduce the $342,000 amount realized by the $100,000 basis in the land, we obtain a gain of $242,000. In short, Ted got more stuff of value, $342,000, than the basis in the acid he gave up, $100,000.