How are realized profits different from unrealized or so-called "paper" profits?
Hi! The other answers here are great, and I wanted to add a thought about how taxes work on unrealized and realized gains. People buy stocks for several reasons including capital appreciation (which occurs when a stock rises in price) and dividends (which are payments made to stockholders when the company distributes some of its earnings to stockholders). So “capital gains” are when you realize capital appreciation by selling the stock. You only take a capital gain in a stock when you actually sell it, and that’s the only time you pay taxes on what you’ve earned. Clients have asked me if they need to pay taxes on a stock that’s appreciated in a year or as in your question, on a stock that shows a "paper profit." In other words, if you spend $1,000 on ABC stock in Jan. 2015 and then at the end of the year the stock has gone up and it is worth $2,000, would you owe the IRS tax on the $1,000 you’ve made that year? In the case of this "paper profit," you wouldn’t owe any tax on the amount you’ve earned so far in 2015 because you haven’t actually realized or locked in that gain. A company you own stock in could feasibly go bankrupt at any moment, so the $1,000 profit you have on paper could disappear and instead of your ABC stock being worth $2,000, it could be worth 0. That’s why you don’t pay taxes on that stock's paper profit – at any moment as the stock market moves and as your stock price moves, your profit changes. It’s only when you sell the stock for more than you paid for it that you realize a capital gain…or a loss when you end up selling it for less than you paid for it or if the company goes bankrupt. Thanks so much for writing to us!
Realized profits means that you have already completed a buy and a sell of the investment. When profits are realized, they are taxable. Unrealized or "paper" profits means that you still own the investment. The profit is on paper, i.e., unrealized, until you sell it. Then it is real and taxable.
Realized profits are gains you actually "nail down" by selling a stock or fund for a price that is higher than what you paid for it. You have unrealized profits when you are holding a stock or fund that is currently trading at a price that is higher than what you paid for it. You have to actually sell a position with unrealized gains in order to have realized gains. When you have realized gains, they can't disappear. Unrealized gains can evaporate if the current price falls to a level below what you paid.
Simply put, realized profits are gains that have been converted into cash. In order words, for you to realize profits from an investment you've made, you must receive cash and not simply witness the market price of your asset increase without selling. For example, if you owned 1,000 common shares of XYZ Corporation, and the firm issued a cash dividend of $0.50 per share, you would realize a profit of $500 from your investment. This is a realized profit because you have received the actual cash, which cannot be lost due to changes in the marketplace.
Similarly, let's say you purchased your 1,000 XYZ shares at $10 per share, for a total investment of $10,000. If XYZ Corp. were presently trading on the market for $15 per share and you sold all of your 1,000 shares on the open market at $15, you would realize a gain of $5,000 on your investment ($15,000 - $10,000).
Now, suppose that XYZ Corp.'s shares were trading at $15, but you believed they were fairly valued at $20 per share, and therefore, you were not willing to sell at $15. Because you would still be holding on to all of your 1,000 shares, you would have an unrealized, or "paper", profit of $5,000. Of course, if you have not closed out of your position and realized your gain, you could still lose some, or all, of your profits - and your principal as well.
On the other hand, because you have not realized your profit, you are not required to claim the gain as income; thus, by holding your shares instead of selling, you can potentially defer taxable income for a year (or many). Of course, the reverse is true for losses - realized losses can usually be claimed by investors as capital losses, offsetting other capital gains, while paper losses can not.
To learn more about profit realization and its implications for investors, check out Selling Losing Securities For A Tax Advantage, A Long-Term Mindset Meets Dreaded Capital-Gains Tax and Tax Tips For The Individual Investor.