Realized vs unrealized gains are fundamental concepts in investing that every investor should understand. These terms refer to the profits or losses on an investment, depending on whether the asset has been sold (realized) or not (unrealized).
These profits and losses are only theoretical until the investment sells. Realized vs unrealized gains (paper profits) are crucial for a successful investment career and will impact your tax planning. Psychologically, unrealized gains can create a false sense of wealth, leading investors to take on more risk than they can afford. For that reason, the important thing is to focus on realized gains.
The term realized and unrealized can refer to stocks, bonds, collectibles, cryptocurrencies, real estate, or any other form of investment.
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Unrealized Gains
We begin our realized vs unrealized gains explanation with unrealized gains, often referred to as paper profits, because they only exist on paper and have not been realized through a sale transaction.
They represent the potential profits of an investment. It is the increase in the market value of an asset compared to its original purchase price.
For example, if you bought a stock for $100 per share and its current market value is $150, you have an unrealized gain of $50 per share. There is no profit yet, and a loss can still occur.
Realized Gains
On the other hand, with realized vs unrealized gains, we have realized gains. The investment sells for a price higher than the original purchase price. There is a profit.
Using the previous example, if you sell the stock at $150 per share, you have realized a gain of $50 per share. Realized gains are taxable, but we will get to that later in the article.
Realized vs Unrealized Gains Importance
For several reasons, it’s important to understand the difference between realized vs unrealized gains.
Tax planning
To begin, realized gains are taxable, while unrealized gains are not. Nobody likes to pay taxes, and you must plan your investment strategies to minimize tax liabilities.
Portfolio management
Unrealized gains represent potential profits. However, they can also become losses if the asset’s value declines. You can make informed decisions about when to sell or hold your investments by monitoring unrealized gains.
Risk management
Unrealized gains can create a false sense of wealth. They can lead you to take on more risk than you can afford. By focusing on realized gains, you can better manage your risk exposure and make decisions based on actual profits.
Unrealized Losses
We can’t discuss realized vs unrealized gains without talking about losses. Unrealized losses are a decrease in the value of an investment that hasn’t sold or closed yet. It represents a paper loss that exists only on paper and not through a sale transaction.
Unrealized losses can be temporary because the value can still rise and become an unrealized gain. However, it would be best if you didn’t hold on to losing trades for too long unless you can afford it or there is a reasonable chance the momentum will swing.
Realized Losses
We conclude this section of realized vs. unrealized gains with realized losses. They are an investor’s worst enemy. Once any asset sells for a loss, that chapter is over, and a new one can begin.
Unfortunately, realized losses can harm our trading psychology. They can create a domino effect, and you can make trades to win what you lost unsuccessfully. Fortunately, realized losses can be beneficial when it comes to tax reporting.
Realized vs Unrealized Gains Tax Implications
Gains and losses have a huge impact on your tax implications. Their timing can be crucial. The following section is for the US only. The rules will differ based on your country and your investment accounts with realized vs unrealized gains.
Unrealized gains
Unrealized gains are not taxable because the investment hasn’t sold yet. In this case, there aren’t any nuances.
Realized gains
Realized capital gains in the US are taxed based on the asset’s holding period and the taxpayer’s income level. Gains from assets held for one year or less before being sold are considered short-term capital gains. They are taxed at the same rate as ordinary income from sources like wages or interest. The tax rate depends on the taxpayer’s taxable income and filing status.
Conversely, gains from assets held for more than one year before being sold are considered long-term capital gains. They receive preferential tax treatment with lower rates than ordinary income. In 2024, the long-term capital gains rates are:
- 0% – for incomes up to $47,025 (single) or $94,050 (married filing jointly).
- 15% – for incomes $47,026 – $518,900 (single) or $94,051 – $583,750 (married filing jointly).
- 20% – for incomes exceeding $518,901 (single) or $583,751 (married filing jointly).
Note: Qualified dividends get taxed at the preferential long-term capital gains rates.
Realized vs Unrealized Gains Special Tax Rules
Finally, special tax rules apply to certain assets with realized vs unrealized gains.
- Collectibles (art, antiques, coins, stamps, etc.) – Taxed at a higher 28% rate for long-term capital gains instead of the regular 20% rate.
- Real estate – Taxed at a maximum rate of 25%. There are special rules for flipped properties held for less than a year, where gains could be treated as ordinary income.
- Business assets – Inventory, depreciable property, copyrights, patents, and other business assets are not eligible for the preferential long-term capital gains rates. They get taxed as ordinary income.
- Non-qualifying securities – Shares of certain non-public corporations, bonds/obligations, etc., may be fully taxable as ordinary income.
Reinvesting Capital Gains
Reinvesting capital gains or dividends in a taxable account prevents you from paying taxes on them in the US. However, the only way to defer taxes on reinvested capital gains and dividends is by holding the investments in tax-advantaged retirement accounts like IRAs and 401(k)s. Within these accounts, you can reinvest without tax until funds are withdrawn during your retirement.
Unrealized losses
One of your holdings is significantly in the red, and it’s toward the end of the year. What do you do? You can sell your investments for tax purposes to realize capital losses. That can be used to offset capital gains and reduce your overall tax liability. This strategy is known as tax-loss harvesting.
Realized losses
We conclude with realized losses. How can they benefit you when it comes time to file your taxes? If capital losses exceed capital gains in a year, up to $3000 of net capital losses can be deducted against ordinary income. Remaining capital losses can be carried forward indefinitely to offset future capital gains. Let’s look at three examples to clear things up:
- If you have $9000 in capital gains and $4000 in losses, you can net them out and only pay taxes on the $5000 net capital gain.
- If you had $8000 in losses but only $5000 in gains, you could deduct the full $3000 net loss against your ordinary income.
- If you had $9000 in losses and $4000 in gains, you could deduct $3000 against income that year and carry forward the remaining $2000 net loss to future years.
Note: This does not apply to realized losses in IRAs or 401(k)s.
Final Thoughts: Realized vs Unrealized Gains
To conclude, realized vs unrealized gains are essential concepts that every investor should understand, regardless of the level. They aren’t only profits and losses. These numbers can have huge implications on taxes and psychology, such as a false sense of wealth. Good luck with your trading and your taxes!
Frequently Asked Questions
Unrealized gains or losses are only theoretical and exist only on paper. Once they sell, they become realized.
No, you do not pay taxes on unrealized gains. You do not have to report them on your tax returns.
Realized gains are taxed like income when they are held for less than one year. After one year, they are considered long-term capital gains and receive preferential tax treatment with lower rates than ordinary income (0%, 15%, or 20%, depending on your income level).
Some assets, such as collectibles, real estate, business assets, and non-qualifying securities, will be taxed at different rates.
