The economic outlook is fantastic, so your portfolio soared in value. You’ve made so much money!
But did you?
Unrealized gains make it look like you’ve made money, but all might not be as it appears.
What are Unrealized Gains?
An unrealized gain is a paper gain. If your investments increase in value, it will appear that you’ve made money on paper, but you haven’t.
Anything can happen with the investment. It can continue soaring in price, or it can crash and burn. As long as you stay the course, you ride the wave wherever it takes you.
Difference Between Realized and Unrealized Gains
The difference between unrealized and realized gains and losses is the difference between real money and conceptual money. Unrealized gains are conceptual, while realized gains are actual. With realized gains, you have the money in your hand (or your brokerage account) and can do whatever you want. You will also have a tax liability with realized gains, as you must pay taxes on any income.
If you have unrealized gains, the profit is locked away in your investment. It’s intangible, and you can’t use it for anything else. It’s also theoretical because the gains vanish if the investment goes back down.
Examples of Unrealized Gains
You can have unrealized gains in nearly any asset, from equities to housing.
Let’s say you bought 1,000 shares of a company for $1 a share, so your cost basis is $ 1,000 (assuming no brokerage fee). If the stock increases in value to $2 a share, your total investment is now worth $2000, so you’ve gained $ 1,000!
But that gain is unrealized because the stock could still go up more or come back down.
The same concept applies to housing. If you bought a house for $200,000 and it’s now worth $300,000, you have $100,000 in unrealized gains. But anything could happen with the housing market. Those gains could be wiped out if the market plummets or could skyrocket if it continues on an upward trajectory.
How Do You Realize a Gain?
If you want to make real money from your investment gains, you must realize them. You realize gains by selling your investment.
In the stock example, you can make $1000 of realized gains by selling when the price hits $2 a share.
The housing example is more complex because your realized gain depends on selling costs, which eat into your profit. Your realized gain from selling the house is the total profit minus the total costs.
What are Unrealized Losses?
Unrealized losses are the opposite of unrealized gains. They are paper losses that become real only when they are locked in.
Examples of Unrealized Losses
Like unrealized gains, you can have unrealized losses in nearly every asset class.
We’ll use the stock and housing examples again to showcase how theoretical losses work in investing.
Imagine that stock you bought for $1 a share plummets to fifty cents per share. In theory, you’ve lost $500. However, until you sell, it’s an unrealized loss. You can still recoup your loss if the stock recovers.
The same concept applies to housing. Let’s say you bought the house for $200,000 in 2007, and in 2008, it plummeted to $100,000. You have an unrealized loss of $100,000.
How Do You Realize a Loss?
You realize your losses when you lock them in. The loss is no longer theoretical, and you’re out real money.
You realize the loss when you sell in both the stock and the housing example.
However, selling isn’t the only way to realize losses. You can also realize a loss with stocks if the company goes bankrupt. There’s no way to recoup any money from a company that no longer exists.
Are Dividends Realized or Unrealized?
Any profit that puts money into your pocket is a realized gain. Therefore, any money you make via dividends counts as realized profit.
Some investors set up automatic dividend reinvesting, meaning they never actually see the profit from their dividends because it gets rolled into their investment. However, it’s still a realized gain. You simply used the profit to buy more investment.
Are Unrealized Gains Taxable?
There typically aren’t any tax liabilities for unrealized gains because, technically, you haven’t made any money yet. You don’t make money until you sell and realize the profit, so there’s nothing for Uncle Sam to tax.
However, the tax code constantly changes. Politicians discussed taxing unrealized gains over a certain threshold a few years ago. In 2023, the Supreme Court ruled that unrealized gains are not income and thus can only be taxed with a direct tax (rather than income tax).
Unrealized gains aren’t taxable, but the opposite is also true. You can’t write off any unrealized losses. Many savvy investors sell certain assets at a loss to “realize” the deficit, using it to off their tax liability when they realize gains from other sales in a process called tax harvesting.
When investing, you must speak with a tax advisor if you have questions about your tax liability.
Understanding Terms Crucial To Successful Investing
Understanding that unrealized gains and losses are conceptual will help you make the right investment decisions.
In the 2008 panic, millions lost fortunes because they panicked over unrealized losses in their investment accounts. They pulled out at the bottom of the market, locking in all those losses.
Those who remained invested through the crash saw their portfolios grow from 2010 through 2020. They stayed the course despite the unrealized losses, and their investments eventually recovered.
Knowing the difference between a real loss and a paper loss is crucial, especially for those in the early phases of their investment journey.
It’s vital to remember that all investments carry risk. The fact that markets recovered and people who stayed invested came out ahead during that crisis doesn’t guarantee the same will happen in future stock market crashes. However, if you’re well diversified, your best bet is usually to stay invested during downturns so you don’t lock in the loss. Speak to a financial advisor for specific advice on what’s right for your situation.
