The concept of unrealized gains and losses is an important one in the investing world. The status of gains and losses determines what happens with them for tax purposes and when and how they are reported. Understanding and tracking unrealized gains and losses can help with tax planning and give you a clearer view of your total investing portfolio.
What is an Unrealized Gain or Loss?
An unrealized gain or loss is an increase or decrease, respectively, in the value of an investment after you purchase it but before you sell it. Once the investment is sold, the difference between the purchase price and the selling price is a realized gain or loss. An unrealized gain or loss changes when the price of the investment changes so, for example, an unrealized loss of $1,000 on an investment can turn into a gain by the time you sell it. Unrealized gains and losses are also called "paper" gains and losses.
The difference between realized and unrealized gains and losses is an important one as it is only realized gains and losses that are taxed. The nature of the tax depends on the type of activity you are engaged in. If you actively manage investments full time, it may be deemed to be a business and realized gains and losses are treated as self-employment income. If you are a passive investor and manage your portfolio on the side, the gains and losses will be treated as capital gains and losses, which get a favorable tax treatment.
Crystallizing Unrealized Gains and Losses
When engaged in tax planning for your portfolio, there are times when you may want to sell some of your investments in order to lock in your gains and losses and turn them from unrealized to realized. This is also known as crystallizing the gains and losses. For example, if you have significant losses in the year, you may wish to sell some stock that is on a steady climb in order to create taxable gains that will not be taxed to the extent that there are losses to absorb them. Alternatively, if you have high realized gains in the year, you may wish to sell off some of your declining investments to soothe the tax burden.
Permanent Vs. Temporary Losses
Your unrealized losses may be either permanent or temporary. Temporary losses are those in which the underlying investment has the possibility of rebounding and erasing or lessening the loss over time. A permanent loss is one where the investment is unlikely to ever recover, such as when a stock has been de-listed from a stock exchange. Permanent losses can be realized at any time without the risk of losing out on an upswing. Managing temporary losses is more complex as the timing of a sale can have a significant impact on taxes.
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