What Is the Difference Between a Realized Gain and an Unrealized Gain?

When you buy a real estate investment property, your goal is likely to make a passive income, grow your portfolio, and eventually sell the property for a profit. The profit you make from selling a property yields what’s known as a realized gain; however, you can predict this profit by calculating the unrealized gain on your investment to understand the best time to sell your property.

Explore the concept of realized and unrealized gains to help you develop a wealth management strategy for your investment properties.

Defining Realized and Unrealized Gain

When an investor sells an asset, like property or stock, for a profit, realized gain is the amount they profited from the sale. By contrast, an unrealized gain is when the value of an asset increases, but the investor does not sell. The gain exists in theory but not in practice, so it’s sometimes called a gain on paper.

Once the investor sells, an unrealized gain becomes a realized gain, turning the expected profit into an actual profit.

In other words, an unrealized gain is what an investor would gain if they sold the asset, while a realized gain is what the investor did gain for selling it.

Calculating Realized and Unrealized Gains

Because an unrealized gain is theoretical, calculating an unrealized gain is straightforward subtraction. The investor simply has to subtract the total purchase price of the asset (including any fees at the time of purchase) from the asset’s current value.

Unrealized Gain = Current Value – Total Purchase Price

Take an investor who purchased a property for $400,000. If the property has appreciated in value to $700,000, they could make $300,000 by selling at its valued price. Since they have not yet sold the property, the $300,000 they could earn is the unrealized gain.

Determining realized gain is slightly more complex but uses the same formula. You subtract all associated costs, including purchase price and selling fees, from the asset’s selling price.

Realized Gain = Total Selling Price – Original Purchase Price – Additional Costs

For example, your property is worth $400,000. If you sell the property for $700,000 and pay $28,000 in closing costs, you’ll realize a gain of $272,000.

Taxes on Realized Gains

You do not need to pay taxes on unrealized gains. The IRS only taxes gains once you sell the property, so you just need to list realized gains on your tax return. If you haven’t sold the asset yet, you don’t need to report any value increases on your property.

If you sell your asset, the IRS applies a capital gains tax to your realized gains. Tax rates are dependent on whether the asset is considered a short-term or long-term capital gain. If you realize a gain on a property you’ve invested in for under a year, it would be treated as a short-term capital gain and taxed at your ordinary income rate.

Long-term capital gains are gains you make on investments held for over a year. The IRS taxes these gains at lower rates than short-term capital gains. So, if you invest in a property that almost immediately increases in value, waiting until the following year to sell it will save you tax money in the long run.

You can use various financial management strategies to defer realized capital gains when you sell a real estate investment, such as a 1031 exchange into like-kind property. This strategy allows you to grow your real estate investment portfolio and defer paying capital gains until you or your beneficiaries sell the property without reinvesting.