Gains and losses are an integral and inevitable part of the investment industry. The main goal for any investor or financial professional is to rack up the gains. But when things don't go the way they're supposed to, there's a very good chance that investment portfolios will experience losses.
But what exactly are they? A gain occurs when the current price of an asset is higher than when it was first purchased. A loss, on the other hand, happens when the current price is lower than the original one. Put simply, a gain is an increase in the value of an asset while a loss refers to the loss of value.
Gains and losses can be realized or unrealized. Realized gains and losses occur when you actually sell or dispose of the asset. Unrealized gains and losses happen when an asset's value changes after it is purchased and hasn't yet been sold. This article examines unrealized gains and losses in a little more detail along with some of the tax consequences associated with them.
- An unrealized gain is an increase in the value of an asset or investment that an investor holds but has not yet sold for cash, such as an open stock position.
- An unrealized loss is a decrease in the value of an asset or investment that an investor holds rather than selling it and realizing the loss.
- A gain or loss becomes realized when the investment is actually sold.
- Capital gains are taxed only when they are realized, while capital losses are deducted only when they are realized.
What Are Unrealized Gains And Losses?
Unrealized Gains and Losses
As noted above, gains can be either realized or unrealized. Realized gains or losses occur when an investor actually sells an asset for more or less than the original purchase price. This means an investor disposes of the asset and cash exchanges hands between them and the seller.
But what happens when the value of an asset changes before it's sold? This is what's called an unrealized gain or loss.
The value of an asset can change at any time, regardless of whether an investor retains or disposes of it in any way. A gain is realized when the asset is disposed of for profit. For instance, you realize a gain of $25,000 when you sell your home for $100,000 after purchasing it for $75,000. If it isn't sold, the risk of loss increases because the potential to make money decreases.
An unrealized gain occurs when an asset's value increases after the investor purchases but doesn't dispose of it. That means the asset's current price is higher than it was when the investor originally purchased it.
Many investors use unrealized gains to calculate how well their investments are doing. As such, unrealized gains allow them to make decisions about their holdings, including when to sell certain assets and whether to make changes to their investment portfolios.
Keep in mind that turning an unrealized gain into a realized one has tax consequences. We go more on this a little further down.
A realized loss is the opposite of a realized gain. It happens when an asset is sold for less than the original purchase price. So if you purchase one share of stock at $50 but end up selling it for $35, you have a loss of $15.
Similarly, an unrealized loss is the opposite of an unrealized gain. It occurs when the price of an asset decreases after an investor buys it, but has yet to sell it. Therefore, the loss remains on the books rather than being physically accounted for by the investor.
If a large loss remains unrealized, the investor probably hopes the asset's fortunes will turn around and its value will increase above the original purchase price. If it continues to decline below the original purchase price, then the investor experiences an even larger unrealized loss for the time they hold onto it.
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.
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.
There are no tax implications associated with unrealized gains and losses. This means you don't have anything to report to the Internal Revenue Service (IRS) on your annual tax return if you have one. But you must report a capital gain or loss if you sell the asset in the tax year that it occurs. Here's how capital gains and losses work.
Capital gains are categorized as short- and long-term capital gains. The former is realized when you hold assets for less than a year while the latter refers to gains realized for those held for longer than a year. Capital gains are taxed at rates of:
- 0% for taxable incomes under $40,400 for single taxpayers ($80,800 for married couples filing jointly)
- 15% for taxable incomes between $40,400 and $445,850 ($80,800 to $501,600 for married couples filing jointly)
- 20% for taxable incomes that exceed the 15% thresholds
- You can use capital losses to reduce your tax burden by offsetting any capital gains that occur in the same year.
- You can use a capital loss to reduce the 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 went out of business or declared bankruptcy. Check with a tax professional about the best strategy for you and the forms you'll need.
Remember that a loss is a loss, regardless of whether it is realized or not. For some investors, learning when to take their gains and cut their losses is the key to long-term investing success.
You can claim a capital loss for any securities you own and relinquish. But you can't claim a deduction for bad debt if they become totally worthless.
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 own the shares, you'd 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 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.