An unrealized gain refers to a potential profit that exists on paper, resulting from an investment that has increased in value but has not yet been sold. Because the investment is still owned and could decrease in value before it is sold, the gain is “unrealized” and thus not considered a concrete profit. Unrealized gains are the opposite of unrealized losses, which occur when an investment decreases in value but has not yet been sold.
In accounting, unrealized gains often do not count as income and therefore are generally not taxable until they become “realized” (i.e., when the asset is actually sold). This can have important implications for tax planning and investment strategy.
Example of an Unrealized Gain
Let’s consider a fictional individual named Alice who decides to invest in the stock market.
Alice buys 100 shares of a tech company called “TechWave” at $50 per share. Her total initial investment is 100 x $50 = $5,000.
Stock Price Increases:
After three months, the stock price of TechWave increases to $60 per share.
Unrealized Gain Calculation:
Now, the value of her investment is 100 x $60 = $6,000.
Her unrealized gain would be the current value of the investment minus the initial cost: $6,000 – $5,000 = $1,000.
Scenario 1: Alice Holds the Stock
- If Alice decides not to sell the shares, her $1,000 gain is considered an “unrealized gain.”
- It exists on paper but is not available as cash, and she does not owe taxes on it.
- If the stock price continues to rise or fall, this unrealized gain will adjust accordingly.
Scenario 2: Alice Sells the Stock
- If Alice sells the stock at the current price of $60 per share, her unrealized gain of $1,000 becomes a “realized gain.”
- She will then have to report this $1,000 as income, and it may be subject to capital gains tax.
Scenario 3: Stock Price Drops Before Selling
- Let’s say Alice doesn’t sell, and the stock price drops to $45 per share.
- Now, her investment is worth 100 x $45 = $4,500.
- She would have an unrealized loss of $5,000 – $4,500 = $500 until she decides to sell the shares.
Financial Statements and Taxes:
- For individual investors like Alice, unrealized gains are usually only relevant for personal financial planning and are not reported for tax purposes until they are realized.
- For companies that hold investments, depending on the accounting standards they follow, unrealized gains may be reported in the financial statements to reflect the fair value of the assets, although they are typically not included in operating income.
This example demonstrates how unrealized gains work and how they differ from realized gains. Until the asset is sold, the gain is unrealized and exists only on paper. Once the asset is sold, the gain becomes realized, and potential tax implications come into play.