Understanding unrealized gains and losses is key to making smart choices when you’re staring down your investment portfolio.
So, what exactly are unrealized gains and losses?
It is the value of a stock (or another asset) compared to the purchase price before you’ve actually sold the asset. You haven’t locked in the gain or the loss yet, so it is unrealized.
For example, if you bought a stock for $10 per share and it’s now worth $12 per share, your unrealized gain is $2 per share. Conversely, if that same stock has fallen in market value to $8 per share, your unrealized loss would be $2 per share. By tracking these changes in value, you can get a better sense of how well (or poorly) your investments are performing. Keep in mind that realized gains and losses only occur when you actually sell the investment.
Important Takeaways
Unrealized gains are the ‘what if’ of investing. “What do I gain if I sell now?” or “What will I lose if I sell now?”.
Understanding your unrealized gains and losses allows for a spot-check review of the investment’s performance.
Until you’ve sold the asset, you only have the potential for gain or loss because you haven’t cashed out.
Unrealized Gain/Loss
The IRS defines all investments as either being a capital asset or inventory. Capital assets are typically shares of stock, bonds, mutual funds, and ETF’s (exchange traded funds), while inventory items are real estate, cars, and collectibles like art.
Unrealized gains come about when the price of an investment goes up, but you haven’t sold it yet.
For example, let’s say you invested $6,000 in shares of Company XYZ on January 1st, and the shares were worth $10,000 on December 31st. You would have an unrealized gain of $4,000 ($10,000 minus $6,000) as the company has gone up in value since you bought it.
Once you have sold, you create a taxable event, and the IRS requires you to report (and pay taxes on) those real capital gains. You can sometimes create a taxable event by transferring that investment to another entity, such as a retirement account or charitable organization too.
Unrealized Holding Gain
When you buy a stock, you are buying the future earnings of a company. You hope its value increases so you can make a profit when you sell it later. A holding period is a time you hold an investment before you sell it.
Selling too soon can be costly. So what should you do? That’s where the unrealized holding gain comes in.
This type of gain is when a stock has not yet reached its potential value and has not been sold but is worth more than when you originally bought it.
An investor with an unrealized holding gain will have a higher cost basis than if they sold the stock.
Let’s say you bought ten shares of Company XYZ for $10 each, which is a total investment of $100. You waited to sell until the price of shares had gone up to $20 per share. Your holding gain would be the difference between those two numbers:
Before selling your stocks, consider the holding gain that might still follow. Holding onto them could mean more profit in the future!
Unrealized Holding Loss
Many stocks go through dramatic price changes, but a few have the potential to create unrealized holding losses.
An unrealized holding loss is when you have shares of a stock worth less today than when you bought them. This can happen if the stock price falls below your purchase price or the value of the land you own decreases.
There are many reasons why stocks go down in price. One of the most common reasons is that the company isn’t performing well. For example, a company may be having trouble with production. Their product might lose market share to a competitor. There are many market factors that can cause the stock price to drop and create an unrealized holding loss for investors.
Another reason stocks go down is that other companies offer better products at lower prices. That means people buy from them instead of the company that has an unrealized loss.
If you have stocks that are worth less today than when you bought them, there are a few things you can do to avoid an unrealized loss.
● Sell your shares before the end of the year to create a recognized capital loss for tax purposes, as it can offset other gains.
● If you feel the stock may rebound, consider holding onto it and wait for it to return to your purchase price or higher.
● Sell your shares and buy another stock with lower risk potential that has similar returns as the original.
● Speak with your tax and financial advisor before making any decision at all! That’s where their expertise is most valuable.
Focusing on the long term is a critical component of a solid investment strategy. The goal of investing is to buy low and sell high. Therefore, when investing in stocks, it’s good to have a plan for when you want to sell. A good rule of thumb is to have a predetermined time frame for your investment and a predetermined dollar amount, too. This will help you avoid making emotional decisions.
Unrealized Capital Gains Tax
Your unrealized capital gains tax refers to how your capital gains are taxed. These are taxed differently than other forms of income because they represent the increase in value of an asset rather than being based on work or salary. Moreover, capital gains tax rates vary by the type of asset and how long you’ve had it.
Tax law can be complicated and confusing, but understanding your capital gains tax is important for your financial plan. But what about unrealized capital gains? Are there taxes on those?
The good news is that only realized capital gains may be taxed. But it’s important to note how they are taxed. More specifically, capital gains tax is only applied to assets that are classified as capital assets. So, it’s relatively easy to determine when you need to pay capital gains tax. Assets like stocks, bonds, and real estate will all be taxed at the time they are sold.
Unrealized gain on trading investments have no fixed maturity date and can be sold at any time. There are different types of trading investments, such as long-term and short-term. Short-term assets are held for less than a year, while long-term assets are held for over a year.
Capital gains taxes apply to commodities and collectibles, but only if you’ve held those items for more than a year. If you’ve held it for less than a year it is treated as ordinary income.
For example, if you invest in gold bars and then sell them after six months, you’ll report the profit, and it will be taxed as ordinary income. You don’t have to pay capital gains tax because of the short holding period.
However, if you invest in gold bars and sell them after two years, you would have to pay capital gains tax on your profits because the holding period falls under the “long-term” category.
You will owe capital gains tax on assets you sell or exchange after owning them for more than one year. You can also owe capital gains tax if you exchanged one of your assets this year, but it had been in the family for years. This is called a “carryover basis,” meaning that the person who inherits the asset will only have to pay taxes on any gain from when they received the asset.
One of the significant benefits of capital gains tax is that it’s lower than income tax rates. Capital gains tax rates vary depending on a variety of factors, including your income level and type of asset.
For example, if you’re in the 10 percent or 15 percent ordinary-income brackets, long-term capital gains are taxed at 0 percent for many taxpayers. Short-term capital gains are taxed as ordinary income and will be taxed at your marginal rate, which is higher than long-term gains for many people.
One of the most common questions people ask when they have unrealized capital gains is what happens if they sell an asset. First, let’s define “selling an asset.”
Selling an asset occurs when you receive payment for the sale of a capital asset, which is a property you own. You may also be getting a gain or loss from the sale. The type of gain or loss will depend on whether or not you sold your home and how long you owned it, so it’s best to consult a tax professional in this case.
However, please note that if you sell any other type of asset, like stock, bonds, or mutual funds, you must declare any realized gains as part of your income on your taxes and pay taxes based on that amount once the sale is complete.
Where Are Unrealized Gains and Losses Reported?
We’ve already looked into what is unrealized gain/loss. Next, let’s discuss where you can find your unrealized gains and losses.
Unrealized gains and losses are recorded at the custodian where your investments are held. The custodian you use may also provide this information on their monthly or quarterly statements as well.
Conclusion
The distinction between the terms “unrealized gains” and “capital gains” is somewhat misunderstood, so here’s a quick recap of what we covered:
Capital gains are realized when selling an asset for more than its purchase price. For example, if you bought one Bitcoin at $6,000 and sold it at $7,500, you’d realize a capital gain of $1,500.
If you bought one Bitcoin at $500 and still hold it at $35,500, you have an unrealized gain of $30,000.
In the first scenario, you have made a tangible profit and created a taxable event. In the second, you have made money on paper only, and there is no taxable event.
Capital gains rates are usually lower than ordinary income tax rates, so having an understanding of the opportunity within your portfolio can help with tax planning, investment strategy, and more. Knowing the distinction between unrealized gains versus capital gains can be helpful when looking at what kind of investments might work best for your long-term investment strategy.
The advisors at Dechtman Wealth Management can help you put together a plan that incorporates tax reductions strategies while putting you in a position to help you to achieve your financial goals.
