Unrealized Gain

An unrealized gain is the difference between what an asset is currently worth and its adjusted basis, on an asset you have not sold. It is sometimes called a paper gain, and both names carry the same warning: nothing has been received, nothing has been reported, and the figure can fall again before it ever becomes anything else. Its counterpart is a realized gain, which is what an unrealized gain becomes at the moment of a sale or exchange.

The provisions that define a capital gain do not reach an unrealized one, and the reason is structural rather than accidental. IRC 1222 defines short-term and long-term capital gains as gains from the sale or exchange of a capital asset "if and to the extent such gain is taken into account in computing gross income." Until a gain is taken into account, it is not one of the things the section defines. So the statute is not silent about unrealized gains through oversight; it is built on the premise that a gain becomes a tax object at realization and not before.

The useful way to think about an unrealized gain is as an unsettled question with four possible answers, because the tax result differs in all four and the choice among them is usually available.

You sell. The gain is realized, becomes a capital gain, and is taxed for that year. This is the only one of the four endings that produces a tax bill, and it is also the only one most people picture.

You hold it until death. Under IRC 1014 the basis of inherited property is generally reset to its fair market value at the date of death, so the gain that accumulated over the owner's lifetime is never taxed as a capital gain to anyone. The heir who sells promptly afterward has little or no gain to report. The details, including which assets receive this treatment and which do not, belong to the page on the step-up in basis.

You give it away during your lifetime. The gain does not disappear and it is not taxed to you. Property received as a gift generally carries the donor's basis across to the recipient, so the unrealized gain travels with the asset and surfaces when the recipient sells. Giving an appreciated holding to someone is therefore also giving them the tax on it, which is a fact worth knowing in advance rather than after.

You donate it to a qualified charity. A charity that sells the asset pays no tax on the gain, and a donor who gives the appreciated property itself rather than the cash proceeds generally never realizes the gain at all. The conditions on that treatment, including the type of property and the deduction limits, are set out on the page for donating appreciated stock.

What an unrealized gain actually does to most people is change a decision, not a tax return. A large unrealized gain makes selling expensive, and that expense attaches to a position rather than to a judgment about it. The result is a familiar pattern: a holding that has done extremely well becomes a larger and larger share of a portfolio, and the tax that would be due on selling is the reason given for leaving it there.

The question that separates the two considerations is whether you would buy the position today, at today's price, with cash. If the answer is yes, the unrealized gain is irrelevant to the decision. If the answer is no, then the tax is the cost of correcting the allocation rather than a reason to leave it uncorrected, and its size can be compared against the risk being carried. That comparison is a real one and can come out either way; what it should not do is go unasked. Partial sales, using new contributions to build other positions, and giving or donating the appreciated shares rather than selling them are the usual ways the question gets answered somewhere between the two extremes.

One further point of arithmetic, because it changes how a statement reads. An account balance is an unrealized figure. Part of the number, for a taxable account holding appreciated assets, represents tax that has not been paid yet, and spending the money requires realizing enough gain to pay it. Two people with identical balances and different bases do not have identical amounts of money.

You compare the current market value of what you hold with its adjusted basis. The difference is the unrealized gain, and it moves every day the price does. Brokerages display it on a statement, usually as unrealized gain or loss by position, though the figure is only as reliable as the basis behind it, which is the taxpayer's responsibility for older holdings.

A hypothetical example, followed by the four endings applied to the same number. Elena bought 300 shares at $22.00 in 2015, so her basis is $6,600 (300 × $22.00). The shares now trade at $91.00, so the position is worth $27,300 (300 × $91.00) and her unrealized gain is $20,700 ($27,300 − $6,600). She has reported nothing and owes nothing.

If she sells, she realizes a long-term capital gain of $20,700 and reports it for that year. If she holds until death, her heirs generally take a basis of the date-of-death value, so the $20,700 is never taxed as a capital gain to anyone. If she gives the shares to her son, he generally takes her $6,600 basis, so the same $20,700 is waiting for him when he sells. If she donates the shares to a qualified charity, the charity can sell them without tax on the gain and she never realizes it.

Four endings, one number, and the difference between them is far larger than anything the market is likely to do to the position in the meantime.

Pros

• No tax is due while a gain remains unrealized, so the full amount stays invested and compounds rather than being reduced each year.
• The timing of realization is generally the owner's choice, which allows a sale to be placed in a year that suits the rest of the tax picture.
• Three of the four endings avoid the gain being taxed to the owner, so holding genuinely opens options that selling closes.
• It is visible on any statement, so the size of the eventual decision is known long before it has to be made.

Cons

• It is not money. The figure can fall, and a large unrealized gain has been entirely erased by a decline more than once in most investing lifetimes.
• It anchors people to positions they would not choose today, letting a tax consideration override a risk one.
• It makes an account balance overstate what is actually spendable in a taxable account, because part of the number is unsettled tax.
• The figure depends on the basis being right, and for long-held or inherited positions the basis is frequently poorly documented.