This paper presents some proposals about the nature of reality monitoring during sleep and its neurobiological basis. An example of a dream from a psychoanalytic treatment is described in which the dreamer saw his deceased father alive. The dreamer judged in the dream that he had fantasized this before, but in the dream, “this was real.” This example is used to explore several questions: (1) To what degree are the reality-monitoring systems of dreaming and waking unitary or separate? (2) Is “reality” a property of experience that is perceived or assigned? (3) How do affective considerations shape our perception or assignment of reality? (4) Does death of a loved one have a special capacity to modify reality judgments? Finally, (5) what can we learn from neurological data about these psychological phenomena? Data from neuropsychological studies of many types are cited that implicate frontal limbic areas, especially the anterior cingulate, in the process of distinguishing fantasy, dream, and waking reality.