Realized and Unrealized Gains and Losses

by Investing School on March 25, 2009

Realized and unrealized gains are simple to define but the subject almost always lead to interesting discussions. Especially during tax season and at times when the markets are at the extreme conditions, the discussion heats up. Let’s briefly explore this today.

Defining Realized and Unrealized Gains

In the investing world, any asset you own changes value constantly. if you own a stock (for example) and the share price went up after you purchased it, you have a unrealized gain. On the other hand, an unrealized loss occurs when the stock price went down after you bought it.

Realized gains and losses doesn’t happen until you sell the asset. For example, let’s say you buy Intel (INTC) at $13 in January. If it goes up to $15, you have an unrealized gain of $2. However, if you sell it at that price, then the unrealized gain turns into a realized one.

Realized Gains and Taxes

Why is this important? Well, the IRS basically says that taxes are calculated based on capital gains. In other words, the sum of all realized gains and losses. Therefore, there are no tax implications for any asset that you bought but haven’t sold. This sure makes taxes much easier right?

I Don’t Lose Money Until I Sell It

It’s amazing how many people would say this during a market crash, but you will hear this many times while the market is going down:

You didn’t lose that money until you sell the stock!

Unfortunately, this is simply not true. The stock price always represent the last estimate of the price of each share. Even though the losses you incurred are unrealized, it doesn’t mean the losses aren’t real. If you bought 100 shares at $20 and it went down to $10 per share, you have $1,000 worth of stock. If you have to sell it, you will get roughly $1,000. If you have $1,000 to invest, you can double your investment by buying 100 more shares. This has nothing to do with whether the gains or losses were realized or not. Stop kidding yourself and deal with the situation by thinking about your best course of action for the future.

What this Means for Us

For short term investments, you shouldn’t let realized and unrealized gains affect your buying and selling decisions because asset prices change too fast in the short term and may offset any tax implications.

For mid to long term investments, make sure you keep realized and unrealized gains in mind so you aren’t paying more taxes than you need to. For example, it may be beneficial to sell a few losers to offset other realized gains before year end. Just make sure you understand the consequences before you act.

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