Gains and losses are the inevitable outcomes of investing. Every investor seeks gains. But when things don't go as hoped, there's a good chance an investment portfolio will experience losses.
A gain occurs when the current price of an asset rises above what an investor pays. A loss, in contrast, means the price has dropped since the investment was made. Put simply, a gain is an increase in the value of an asset, while a loss refers to the loss of value.
Both gains and losses can be divided into realized and unrealized. Investors realize a gain or a loss when they sell an asset unless the realized price matches exactly what they paid. Unrealized gains and losses reflect changes in the value of an investment before it is sold. This article examines the differences between realized and unrealized gains and losses as well as their respective tax consequences.
Key Takeaways
- An unrealized gain is an increase in the value of an asset or investment that an investor has not sold, such as an open stock position.
- An unrealized loss is a decrease in the value of an ongoing investment.
- A gain or loss on an investment is realized when it is sold.
- Capital gains are taxed and capital losses may be deducted only after they're realized from the sale of an asset.
- Unrealized gains and losses remain subject to change, but they can help you minimize the taxes you owe.
Dealing With Unrealized Gains
The value of a financial asset traded in financial markets can change any time those markets are open for trading, even if an investor does nothing.
For example, if you bought stock in Acme, Inc, at $30 per share and the most recent quoted price is $42, you're sitting on an unrealized gain of $12 per share. You could realize that gain if you sold Acme at $42 per share. Otherwise, your bottom line would continue to fluctuate with the share price.
Unrealized gains and losses are also called paper profits or losses. That's because the gain or loss only exists while the asset is in the investor's possession and on paper, generally on the investor's ledger.
Handling Unrealized Losses
A realized loss is the opposite of a realized gain. It happens when an asset is sold for less than its purchase price. So if you purchase a share of stock at $50 but end up selling it for $35, you have realized a loss of $15.
Similarly, an unrealized loss is the opposite of an unrealized gain. It occurs when the price of a current investment declines below its purchase price. The loss remains unrealized until the investment is sold, at which point it becomes realized.
Advisor Insight
Theodore E. Saade, CFP®, AIF®, CMFC
Signature Estate & Investment Advisors LLC, Los Angeles, CA
Unrealized gains and losses (aka “paper” gains/losses) are the amount you are either up or down on the securities you’ve purchased but not yet sold. Generally, unrealized gains/losses do not affect you until you actually sell the security and thus “realize” the gain/loss. You will then be subject to taxation, assuming the assets were not in a tax-deferred account.
If, say, you bought 100 shares of stock “XYZ” for $20 per share and they rose to $40 per share, you’d have an unrealized gain of $2,000. If you were to sell this position, you’d have a realized gain of $2,000, and owe taxes on it.
Tax-loss harvesting, short/long term capital gain consideration, and your income tax bracket, are important factors to consider when deciding on what steps to take with positions at a gain or loss.
Assessing Tax Consequences
There are no immediate tax implications associated with unrealized gains and losses. Until an investment is sold its performance is not reported to the Internal Revenue Service (IRS) and has no bearing on the investor's taxes owed.
At the same time, calculating your unrealized gains (or losses) in a taxable investment account is essential for figuring out the tax consequences of a sale. Because realized capital losses can offset otherwise taxable capital gains and, to a limited extent, ordinary taxable income, many investors attempt to time asset sales in a way that minimizes their tax bill.
How Capital Gains Are Taxed
You must report a capital gain or loss on the tax return for the year in which the asset was sold. Capital gains are categorized as short- and long-term. Short-term capital gains refer to realized gains on assets held for a year or less and are taxed as ordinary income. To qualify for the lower tax rates on long-term capital gains, an investment must have been held for more than a year.
Long-term capital gains are taxed at the following rates for 2023:
- 0% for taxpayers with taxable income of $44,625 or less for single filers ($41,675 or less in 2022) or $89,250 for married couples filing jointly ($83,350 or less in 2022)
- 15% for single filers with taxable income between $44,626 and $492,300 ($41,676 and $459,750 in 2022) or between $89,251 and $553,850 for married couples filing jointly (between $83,356 and $517,200 in 2022)
- 20% for taxable incomes that exceed the 15% thresholds
When you claim capital losses, make sure you're strategic about how you deduct them. For instance:
- You can use capital losses to reduce your tax burden by offsetting any capital gains that occur in the same year.
- You can roll over capital losses to reduce your tax burden of future capital gains.
- You can use a capital loss to offset ordinary income up to the allowed amount even if you don't have any capital gains that year.
You might be able to take a total capital loss on a stock you own that goes to zero because the company declared bankruptcy. Check with a tax professional about the best strategy for you and the forms you'll need.
You can claim a capital loss for any securities you own and relinquish, but there are restrictions on deducting uncollectible bad debts.
Example of Unrealized Gains and Losses
Let's say you buy shares in TSJ Sports Conglomerate at $10 per share. But the price plummets to $3 per share shortly thereafter. You decide not to sell it at this point, which means you have an unrealized loss of $7 per share. That's because the value of your shares is $7 dollars less than when you first entered into the position.
Now, let's say the company's fortunes shift and the share price soars to $18. Since you still own the shares, you now have an unrealized gain of $8 per share—$8 above where you first bought into the company.
How Are Unrealized Gains and Losses Accounted for?
Unlike realized capital gains and losses, unrealized gains and losses are not reported to the IRS. But investors and companies often record them on their balance sheets to indicate the changes in values of any assets (or debts) that haven't been realized or settled as of yet.
Are Unrealized Gains Taxed?
Unrealized gains are not taxed by the IRS. This means you don't have to report them on your annual tax return. Capital gains are only taxed if they are realized, which means you dispose of the asset. These gains must be reported in the year they occur.
Can I Invest My Capital Gains to Avoid Paying Taxes?
There are certain investments that reinvest capital gains, thereby allowing you to avoid paying taxes. For instance, capital gains that are realized for mutual funds or stocks held in a retirement account may be reinvested automatically on a tax-free basis. This means you don't have to report them and, as such, don't increase your tax burden.
The Bottom Line
Selling an asset may result in a capital gain or loss. This depends on whether its value increases or decreases from the original purchase price. But you can still experience a gain or loss even if you don't dispose of the asset. This is called an unrealized gain or loss. Although you may not make or lose money from unrealized gains and losses, they can help you make important decisions about your investment portfolio so it's important to keep track of how your assets are performing.
