February 2, 2021
It’s normal to see the investments in your portfolio going up and down in value over time. But just because you see some gains or losses on paper on a certain day doesn’t mean they’re permanent.
A portfolio’s balance can fluctuate day to day depending on what’s going on in the markets. A “loss” this week could become a “gain” next week (or vice versa). That’s because gains and losses are considered “unrealized” until you actually sell the investment (be it a stock, bond or other type of security). In other words, you only “realize” your gains and losses when the investment is sold.
This might sound like we’re just splitting hairs. But the distinction between unrealized and realized gains/losses is an important one because there are tax implications that could impact your tax bill at the end of the year. (If you’ve been an avid reader of our investing articles, this shouldn’t come as a surprise. Investing and taxes go together like cheese and crackers – albeit, a less delicious combo.)
Grab your snack of choice and let’s go over the difference between unrealized and realized gains/losses.
You’re probably already familiar with the concept of gains and losses. But here’s a quick review: A gain is when your investment – let’s say a stock – increases in value after you purchase it. A loss is when the stock decreases in value after your purchase.
As we’ve mentioned, the gains and losses you see in your portfolio are considered “unrealized” until you sell the investment. That’s why unrealized gains/losses are sometimes called “paper” profits or losses. Because until you actually sell the investment, your gains or losses are simply numbers on a piece of paper.
Unrealized gains/losses aren’t “locked in.” This means that if you’re holding onto assets with unrealized losses, it’s possible for them to become unrealized gains when the market is having a good week. Or vice versa.
Let’s look at a basic example. Say you purchased a share of Stock XYZ for $50 last month. This month, you noticed that the stock price has dropped to $40 a share. You hold onto the stock because you know market fluctuations are normal. You now have an unrealized loss of $10 on Stock XYZ because the value of the stock is $10 less than the original purchase price of $50.
Fast forward to six months down the road – Stock XYZ is now valued at $70 per share. You’re still holding onto the stock, which means you have an unrealized gain of $20 per share (or $20 more than your original purchase price of $50).
If you sell an investment and make a profit, that’s a realized gain. On the other hand, if you sell it at a loss (that is, for less than the original purchase price), you have a realized loss.
Realized gains/losses matter because they could impact your tax bill at the end of the year.
Before we start talking about taxes, keep in mind that investment taxes can get complicated. While we’ll go over the basics with you, it’s still a good idea to consult your tax advisor if you have any questions about your personal tax situation.
With that out of the way, let’s look at the basics of the federal capital gains tax.
Realized gains are usually subject to the capital gains tax. Capital gain is simply another term for the profits that you make when you sell an asset such as a stock, bond or Exchange-Traded Fund (ETF).
Generally speaking, the tax you pay on your realized capital gains depends on how long you’ve held onto your investments (short-term vs. long-term).
Because you could sell multiple assets in a given year, it can get a little tricky trying to figure out your potential capital gains tax. You typically need to figure out details like: how long you held onto the assets; cost basis (translation: generally, how much you originally paid for the assets); and net capital gain/loss.
These calculations are no walk in the park, so it’s a good idea to consult with a professional tax advisor who can help you accurately crunch the numbers.
Now, what about capital losses?
In a tough investment year, you might experience a “capital loss,” where you lose money from your investment sales. Generally, you can deduct up to $3,000 net capital losses a year on your tax return ($1,500 if married filing separately).
If you’re planning on deducting tax losses, consult a tax professional for more information on any IRS rules that may apply to you (see IRS Publication 550).
You might be wondering how you could keep track of all your realized gains and losses in a given year (especially if you have a lot going on in your portfolio).
Thankfully, your financial institution may be able to lend a hand. If you have an investment account, your financial firm will typically send you information about your holdings each year, which you can use to help file your tax return.
You may either get these tax documents in the mail or online. These tax documents are essentially a summary report on the various types of income generated by your investments such as stocks, bonds, mutual funds and ETFs – as well as a form listing capital gains or losses from any securities sales.
But remember: Everyone’s financial situation is different. Check in with your financial and tax advisors if you have any questions about your investment gains and losses and how they might impact your year-end taxes.
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