What Is an Unrealized Gain?
An unrealized gain occurs when the current market value of an asset exceeds its original purchase price or book value, but the asset has not been sold. It is sometimes called a "paper" gain, since it only exists as an accounting entry until it is realized. A paper loss is similarly an unrealized loss.
An unrealized gain becomes realized once the position is ultimately sold for a profit. It is possible for an unrealized gain to be erased if the asset's value drops below the price at which it was bought.
Key Takeaways
- An unrealized gain is a theoretical profit that exists on paper, resulting from an investment that has not yet been sold for cash.
- Unrealized gains are recorded on financial statements differently depending on the type of security, whether they are held-for-trading, held-to-maturity, or available-for-sale.
- Gains do not affect taxes until the investment is sold and the gain is realized.
- If an investment is held for longer than a year, the profit is taxed at the capital gains tax rate.
- An unrealized loss is the opposite of an unrealized gain where an investment has decreased in value but has not yet been sold.
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How an Unrealized Gain Works
An unrealized gain occurs when the current price of a security is higher than the price the investor initially paid for the security, including any fees associated with the purchase. Many investors calculate the current value of their investment portfolios based on unrealized values. In general, capital gains are taxed only when they are sold and become realized.
Investors may choose to sit on unrealized gains for tax benefits. Most assets held for more than one year are taxed at the long-term capital gains tax rate, which is either 0%, 15%, or 20% depending on one's income. Assets held for one year or less are taxed as ordinary income, with rates ranging from 10% to 37%.
Taxes on Realized Gains
For tax years 2023 and 2024, a single filer making up to $44,625 would not pay tax on their realized long-term capital gains, and an individual making $492,300 will pay only 15%. Above that threshold, the rate is 20%. If those same people held their investments for one year or less, their short-term realized gains would be taxed as ordinary income, at their respective marginal tax rate.
An investor may thus choose to wait to sell investments if gains realized late in the year would place them in a higher tax bracket and, thus, increase their tax burden. That investor may be better off waiting until January to sell, at which point they can incorporate that profit into their tax plan for the year.
When there are unrealized gains present, it usually means an investor believes the investment has room for higher future gains. Otherwise, they would sell now and recognize the current gain.
Recording Unrealized Gains
Unrealized gains are recorded differently depending on the type of security. Securities that are held to maturity are not recorded in financial statements, but the company may decide to include a disclosure about them in the footnotes of its financial statements.
Securities that are held for trading are recorded on the balance sheet at theirfair value, and the unrealized gains and losses are recorded on the income statement.
The increase or decrease in the fair value of held-for-trading securities impacts the company's net income and its earnings per share (EPS). Securities that are available for sale are also recorded on a company's balance sheet as an asset at fair value. However, the unrealized gains and losses are recorded in comprehensive income on the balance sheet.
Unrealized Gain vs. Unrealized Loss
The opposite of an unrealized gain is an unrealized loss. This type of loss occurs when an investor holds onto a losing investment, such as a stock that has dropped in value since the position was opened. Similar to an unrealized gain, a loss becomes realized once the position is closed at a loss.
Unrealized gains and unrealized losses are often called "paper" profits or losses since the actual gain or loss is not determined until the position is closed. A position with an unrealized gain may eventually turn into a position with an unrealized loss as the market fluctuates and vice versa.
Example of an Unrealized Gain
Say an investor purchased 100 shares of stock in ABC Company at $10 per share, and the value of the shares subsequently rises to $12 per share, but they refrain from selling.
The unrealized gain on the shares still in their possession would be $200 ($2 per share x 100 shares).
If the investor eventually sells the shares when the trading price rises to $14, they will record a realized gain of $400 ($4 per share x 100 shares).
Why Aren't Unrealized Gains Usually Taxed?
The tax treatment of most unrealized gains is rooted in the principle of realization, which holds that income should only be taxed when it's actually received. This approach was solidified in the U.S. by the Supreme Court case Eisner v. Macomber in 1920, which ruled that stock dividends weren't taxable income because they didn't result in realized gains.
Are There Circ*mstances Where Unrealized Gains Can Be Taxed?
Yes, there are some exceptions for the tax-exemption to unrealized gains. For instance, mark-to-market accounting rules require certain financial instruments to be valued at current market prices, potentially leading to taxation on unrealized gains. Also, some countries impose wealth taxes that would effectively tax unrealized gains on assets.
What Is the "Step-Up Rule" with Regard to Unrealized Gains?
The "step-up in basis" rule in the U.S. tax code allows heirs to inherit assets at their current market value, effectively erasing any unrealized gains when assets are passed down. This has been controversial because it effectively allows wealthy individuals to pass on significant appreciation tax-free. There have been some proposals to modify or eliminate this rule to increase tax revenue and address wealth inequality.
Is It Possible to Never Realize an Unrealized Gain?
Yes, it is possible to never realize an unrealized gain. An investor might choose to hold an asset with an unrealized gain indefinitely, perhaps as part of a long-term investment strategy or to pass it on to heirs. In some jurisdictions, donating an appreciated asset to a qualified charity allows the donor to avoid realizing the gain while still receiving a tax deduction. Alternatively, the asset's value could decrease back to or below the original purchase price before it's sold, eliminating the unrealized gain. And, in certain retirement accounts (e.g., a Roth IRA), gains are never "realized" in a taxable sense, though the account holder does benefit from the growth.
The Bottom Line
Unrealized gains, also known as "paper gains," refer to the increase in value of an asset that has not yet been sold. These gains exist only on paper or in theory, but have not been converted into actual profit through a sale transaction. For example, if you buy a stock for $100 and its market value rises to $150, you have an unrealized gain of $50. This gain remains unrealized until you sell the stock and lock in the profit. Unrealized gains are important in financial planning and investing, as they represent potential profit, but they can also fluctuate with market conditions and are not guaranteed until the asset is sold. Generally, unrealized gains are not taxable because the profit hasn't been "realized" through a sale.
