Calculating Amount Realized
In order to have an "amount realized" there must be a kind of exchange. This exchange is known as a "realization event." The first step in calculating the amount realized is determining when an exchange that qualifies as a "realization event" has occurred. Section 1001 requires that there be an exchange where the taxpayer receives money or other property in the transaction. In Helvering v. Bruun, the United States Supreme Court has held that a "ain may occur as a result of exchange of property, payment of the taxpayer's indebtedness, relief from a liability, or other profit realized from the completion of a transaction." To state it more clearly, the Supreme Court lists four events that trigger realization of gain or loss: 1) a property exchange, 2) relief of a legal obligation owed to a third party, 3) relief of a legal obligation owed to the party receiving property, and 4) other profit transactions.
A good illustration for determining realization for income tax purposes is stock. For example: at the beginning of the taxable year, Sally buys stock in XYZ Corp. for $10 per share. By the end of the taxable year, Sally's stock in XYZ Corp. is worth $20 a share. In this case, would Sally have to report the appreciation in her stock as taxable income? Because Sally has not sold her stock (or otherwise exchanged it), she has not realized the stock's appreciation. If Sally had sold the stock in XYZ Corp. at $20 per share, the sale would be a realization event whereby Sally would recognize income (in this case, a gain). Realization would also occur if Sally exchanged her stock for a new car or for a certain amount of services.
In a transaction where property is exchanged for other property, no realization event occurs where this is no legal distinction between the exchanged properties. According to the Supreme Court in Cottage Savings,
nder our interpretation of § 1001(a), an exchange of property gives rise to a realization event so long as the exchanged properties are "materially different"—that is, so long as they embody legally distinct entitlements.
The facts in Cottage Savings present an example of where realization occurs when property is exchanged for property. Cottage Savings Association (CSA) sold interest in home mortgages to four savings and loans associations. At the same time, CSA bought interest in mortgages held by the same four savings and loans associations. "The fair market value of the package of participation interests exchanged by each side was approximately $4.5 million." (Essentially, CSA and the four savings and loans associations exchanged $4.5 million worth of mortgage interests.) The Supreme Court held that a realization event under § 1001 had occurred:
ecause the participation interests exchanged by Cottage Savings and the other derived from loans that were made to different obligors and secured by different homes, the exchanged interests did embody legally distinct entitlements. Consequently, we conclude that Cottage Savings realized its losses at the point of the exchange.
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