A realized loss occurs when an asset or investment is sold for a price lower than its original purchase price (or cost basis). In contrast to a “realized gain,” which represents a profit, a realized loss represents a financial loss that has been “locked in” because the asset or investment has been sold. This stands in contrast to an “unrealized loss,” where the value of the asset has decreased on paper, but the asset has not yet been sold.
The importance of distinguishing between “realized” and “unrealized” is that a realized loss often has tax implications. Depending on jurisdiction and tax laws, realized capital losses can sometimes be used to offset realized capital gains or a certain amount of other types of income, reducing taxable income.
Formula for Realized Loss:
Realized Loss = Original Purchase Price (or Cost Basis) − Selling Price
Example of a Realized Loss
Let’s provide a different example using a real-world scenario involving a collector’s item.
Example: Sale of a Collector’s Painting
Scenario: Sarah, an art enthusiast, bought a painting from a local artist, believing it would appreciate in value over time. However, trends in the art world shifted, and the demand for that particular artist’s work diminished.
- Original Purchase: In 2018, Sarah bought the painting for $10,000, expecting its value to rise as the artist gained prominence.
- Current Market Conditions: By 2023, the artist’s work fell out of favor, and the broader art community lost interest. Realizing she might not recover her initial investment if the trend continued, Sarah decided to sell the painting.
- Sale: Sarah found a buyer and managed to sell the painting for $7,500, which was the best offer she received.
- Determine the Realized Loss:
Realized Loss = Original Purchase Price – Selling Price
= $10,000 (original cost) – $7,500 (selling price)
In this scenario, Sarah incurs a realized loss of $2,500 on the sale of the painting. This means she suffered an actual financial loss of this amount by selling the painting below its purchase price.
If Sarah had been holding the painting purely for investment purposes (as opposed to personal enjoyment), she might consider the realized loss for tax purposes. Depending on her jurisdiction’s tax laws, she might be able to use this loss to offset other capital gains or reduce taxable income for the year. Always consult with a tax professional to understand the specific implications of such transactions.