FFR 289 – Unrealized vs Realized Gains

Financial Flash #289 – Unrealized vs Realized Gains:

Welcome to this week’s Financial Flash Report. I’m Bradford Aylin, Private Wealth Manager at Stiles Financial.

Today we are going to talk about a question that comes up often with taxable brokerage accounts: if your investments go up in value, do you owe taxes right away?

The answer is no, not unless the gain is realized.

The key distinction is between unrealized gains and realized gains.

An unrealized gain simply means an investment has increased in value, but you have not sold it yet. For example, if you bought an investment for $50,000 and today it is worth $70,000, you have a $20,000 unrealized gain.

That does not mean you owe capital gains tax today. Under today’s tax code, you do not pay capital gains tax just because the investment went up in value. The gain is unrealized because you are still holding the investment.

A realized gain happens when you sell the investment for more than you paid for it.

The amount you originally invested is known as your cost basis. So if your cost basis was $50,000 and you sell the investment for $70,000, you have realized a $20,000 gain. That is when capital gains taxes come into play.

From there, the next question is how long you held the investment before selling it.

If you held the investment for one year or less, it is considered a short-term capital gain. Short-term gains are taxed at ordinary income tax rates, which means they are taxed similarly to wages, IRA distributions, or other ordinary income.

If you held the investment for more than one year, it is considered a long-term capital gain. Long-term gains receive more favorable federal tax treatment and are taxed at 0%, 15%, or 20%, depending on your taxable income. For higher-income taxpayers, there may also be an additional 3.8% net investment income tax.

So, in many cases, the difference between selling after a few months and selling after more than a year can have a meaningful impact on your tax bill.

A home sale is another helpful example. If you sell your home for more than you paid for it, that can create a capital gain. However, if it was your primary residence and you meet certain ownership and use rules, you may be able to exclude up to $250,000 of gain if single, or up to $500,000 if married filing jointly.

That is a specific rule for a primary residence, but the broader concept is similar. You do not have a taxable capital gain until something is sold at a gain.

Now, capital gains are only one part of the tax picture.

In a taxable brokerage account, dividends and interest can also create taxable income. The important difference is that dividends and interest are taxed in the year they are paid, even if you do not sell the investment.

Interest is typically taxed as ordinary income. Dividends can be taxed as ordinary dividends, or if they are qualified dividends, they may receive the more favorable long-term capital gains tax rates.

This is different from retirement accounts.

Inside a traditional IRA or 401(k), dividends, interest, and capital gains do not create an annual tax bill while the money remains inside the account. Instead, taxes apply when money is distributed from the account.

Inside a Roth IRA or Roth 401(k), capital gains, dividends, and interest do not create an annual tax bill either. And if the proper Roth rules are followed, qualified withdrawals can be tax free. That is one of the reasons Roth accounts can be so powerful over time.

So when we are talking about unrealized gains, realized gains, dividends, interest, and tax loss harvesting, we are mainly talking about taxable brokerage accounts.

One planning opportunity within taxable accounts is tax loss harvesting.

This is when you sell an investment at a loss to help offset realized capital gains elsewhere in the portfolio. If your losses exceed your gains, you can use up to $3,000 of excess capital losses to offset ordinary income in that year. Any remaining losses can be carried forward to future years.

But tax loss harvesting needs to be done carefully because of the wash sale rule. In simple terms, if you sell an investment at a loss and then buy the same or a substantially identical investment within 30 days before or after the sale, that loss may be disallowed for current tax purposes.

The big takeaway is this: not every gain creates a tax bill right away.

If your investment has gone up in value but you have not sold it, that is an unrealized gain. If you sell it for a profit, that is a realized gain, and that is when taxes apply.

Understanding the difference can help you make better decisions about when to sell, how to manage your tax bill, and how your taxable brokerage account fits into your broader financial plan.

Thank you for joining me today. If you have questions about how your taxable accounts fit into your overall tax and investment strategy, we are here to help.

Have a great weekend, and we will see you in the next Financial Flash.

Disclaimer:
Stiles Financial Services is an SEC registered investment adviser based in Minnesota. Information presented is for educational purposes only and does not constitute an offer or solicitation to buy or sell any securities or investment strategies. Investments involve risk and are not guaranteed. Past performance is not indicative of future results.