While most investors are looking to profit from each investment they make, they sometimes get carried away by unrealized gains and losses. So what exactly are unrealized gains and losses?
Both gains and losses can only be accounted for when an investor or company sells. Therefore, unrealized gains and losses are common terms to describe profits and losses that have not been realized. Unrealized gains and losses can be applied to both a retail investor’s or a company’s investment.
In this article, we will go over the concepts of realized and unrealized gains and losses, and understand the implications on returns and taxes.
What is an unrealized gain?
An unrealized gain happens when one of your investments has a market value above your purchasing price, but you have not sold it yet. This means that the profits are not realized yet, and therefore they cannot be taxed.
Unrealized gains are not taxed until they are realized. Therefore, it is often advantageous to leave your capital in one investment or portfolio for a long time to avoid paying higher taxes over and over again with each sale of your assets.
Example of an unrealized gain
If an investor decides to buy 100 shares of stock XYZ, at $10 a share, the total investment would be $1,000. If the stock goes up by 50%, its initial position now has a market value of $15 a share or $1,500 in total.
Until the investor decides to sell the stock, the $500 of profit constitutes an unrealized gain. Therefore it cannot be taxed, and it cannot be considered profit until it is sold and realized.
What is an unrealized loss?
Similar to an unrealized gain, an unrealized loss is an investment that has a market value lower than its purchasing price. Therefore the investment is currently at a loss, but until the investor sells and realizes the loss, the investment will be a realized loss.
An unrealized loss is a decrease in the value of an asset that has not yet been sold. Unrealized losses are important in making decisions regarding taxes and investment revenue.
For example, an investor might choose to realize losses in order to pay fewer taxes on their capital gains that year if they think the losing asset is unlikely to rise in value soon.
Unrealized loss example
If an investor decides to buy 100 shares of stock XYZ, at $10 a share, the total investment would be $1,000. If the stock goes down by 50%, its initial position now has a market value of $5 a share or $500 in total.
Until the investor decides to sell the stock, the $500 loss constitutes an unrealized loss. Therefore it cannot be considered a loss until it is sold and realized.
Understanding realized gains and losses
Assets tend to fluctuate in value over time. For example, a person’s assets may lose $10,000 in value over the course of a year, then rise in value the next year.
In this case, their losses from the first year are unrealized until they sell their assets.
Once someone sells their investment, their gains or losses are realized.
Gains are only taxed once they sell their investment and realize them. Losses are only tax-deductible once they’re realized. When an investment is sold, the realized gains and losses are reported to the IRS and taxed as capital gains and losses.
Generally, the capital gains tax that someone pays is based on how long they’ve been holding the investment. There are two types of capital gains: short-term and long-term capital gains.
Long-term capital gains refer to any investment that is owned for more than a year (with some exceptions). Generally, the tax rate is 0%, 15%, or 20% on long-term capital gains depending on the person’s taxable income. The long-term capital gains tax rates for 2022 are as follows:
- 0% for ordinary taxable incomes up to $40,400 per year for single and married taxpayers filing separately, $80,800 for married filing jointly, and $55,800 for a head of household
- 15% for incomes from $41,676 to $459,750 for those filing single, $83,351 to $517,200 for married filing jointly, $41,676 to $258,600 for married filing separately, and $55,801 to $488,500 for head of household
- 20% for incomes above $459,750 for single, $517,200 for married filing jointly, $258,600 for married filing separately, and $488,500 for the head of household
Short-term capital gains are taxed at a person’s ordinary income tax rate. The 2021 tax brackets were 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. Notice there is no 0% rate. This can make a big difference for someone going into retirement or in another situation where they won’t have as much taxable income.
Because short-term capital gains are generally taxed at a higher rate, passive investors get to keep more of their gains by paying less tax. Additionally, there are many tax-advantaged long-term investment accounts for purposes such as retirement, education savings, and healthcare expenses. A Roth IRA, for instance, does not require the investor to pay tax on their gains because the contributions to the IRA are made with after-tax income. The capital gains and dividends in a Roth IRA can also be reinvested tax-free and give way to more capital gains.
Because of the way short- and long-term capital gains are taxed, someone can pay less in tax while making more gains by holding their investment for longer than a year.
There are many intricacies to taxes and these rules may vary depending on a person’s financial and tax situation. It’s always best to consult a tax professional for advice on a personal tax situation.
Capital losses can be used to deduct taxes from capital gains or ordinary income. They can also be rolled over to reduce taxes on future capital gains. Therefore, investors often try to time the realization of their capital gains and losses to align with their tax goals.
Note: if a company declares bankruptcy and a stockholder is left with no way to sell their stocks, they can claim their full-purchase price as a total capital loss. However, it must be within the tax year that the company filed for bankruptcy and the stock must be completely worthless, not just worth very little.
Capital losses can reduce a person’s taxable income by up to $3,000 each year but there is no limit to the capital gains tax they can offset each year with losses.
Realizing Capital Gains on Real Estate
The rules of realizing capital gains and losses also apply to real estate. However, the specifics are different.
In order for profits on a person’s main home to be considered long-term capital gains, they must own it and have lived in it for at least two of the five years leading up to the sale. The owner can avoid up to $250,000 in taxes this way if they’re single, and $500,000 if they’re married filing jointly.
For investment property, the capital gains rate can be higher. In general, a 25% capital gains tax rate will apply when the gains are realized and the property is sold. The IRS uses a higher capital gains rate to offset the tax breaks that investors receive through depreciation.
Understanding realized and unrealized gains and losses are very important to ensure a person gets the best deal on their taxes. It’s also crucial to understand investing as a whole. The subject of capital gains taxes regarding realizing gains and losses is a very large field with lots of information and rules.
There are state taxes that will also apply in many cases and other things that will affect an investor’s decision of whether or not to realize their gains/losses. If someone is looking for an all-encompassing insight into their taxes or is seeking investment advice, they should always consult with a professional.