What Is the Difference between Realized and Unrealized Gains?
A realized gain is an investor's amount of gain when selling an asset. The amount is determined by subtracting the adjusted basis from the net sales price. For example, suppose the investor bought a property for $200,000 and spent $50,000 to improve it, then sold it for $350,000. If there were $30,000 in closing costs, the net sales price is $320,000 while the adjusted basis is $250,000, leaving a realized gain of $70,000. In contrast, an unrealized gain can be considered a paper gain. For example, suppose the investor buys a property for $400,000, and while they own it, the value rises to $750,000. The investor has a theoretical gain of $350,000, but the gain remains unrealized unless they sell the asset.
Suppose that the investor continues to hold on to that asset while it rises in value. That initial $400,000 investment property may have a market value of far more. However, markets and values change, and the value can also decrease. If the investor has not sold the asset and the value drops, the unrealized gain may decline or disappear.
How Are Gains Taxed?
Capital gains can be short or long-term, and the tax rate applied to each type differs. Keep in mind that capital assets include more than real estate; the category consists of stocks, bonds, collectibles, jewelry, art, and other items of value. As long as the investor holds the asset without selling it, they don't have to pay taxes. In addition, if the owner bequeaths a capital asset to their heir, the heir benefits from an adjustment to the value (step-up) to avoid paying capital gains taxes.
If the owner sells an asset they have owned for less than one year, any gain is a short-term capital gain and is taxed at the same rate as ordinary income (usually wages), which can be up to 37 percent. Investors can offset short-term gains with short-term losses. If the investor owns the asset for more than one year before selling it, the gain is considered long-term, and the tax is levied according to the lower long-term capital gains rates. Currently, the three tiers are zero, fifteen, and twenty percent, depending on the taxpayer’s income. The rate applied to long-term capital gains sometimes changes and could increase.
What Is the Adjusted Basis?
The capital gain is determined by calculating the difference between the net sales price and the adjusted basis. To determine the adjusted basis, add the acquisition cost (price plus closing costs) plus capital improvements, minus previous depreciation deductions and any deferred capital gains. For example, a deferred capital gain could result from an earlier disposition of property in which the investor chose to postpone the recognition of the growth by employing a Section 1031 exchange. In that scenario, the owner may have accumulated gains on the earlier sales that now become part of the adjusted basis.
What if I Have a Loss?
Investors can offset gains with losses. For example, if you sell one asset and realize a capital gain of $100,000, but you sell another asset at a loss of $50,000, your net gain for tax purposes is $50,000. Investors can also use a capital loss to offset ordinary income (or short-term gains) if the loss is greater than the capital gain for that year. Investors can also carry over losses to future years to offset future gains.
