Unlocking the Potential: What is a Realized Gain?
A realized gain arises from selling an asset for a price higher than its original purchase price. It occurs when an asset is sold above its book value cost.
While an asset may be reflected on a balance sheet at a value much higher than the cost, any gains while the asset is held are considered unrealized gains since they represent fair market value. Conversely, if the asset sale results in a loss, it translates to a realized loss.
A realized gain can be differentiated from an unrealized gain.
Key Takeaways
- A realized gain occurs when an investment is sold for more than its purchase price.
- Realized gains are often subject to capital gains tax. Depending on how long the asset was held, it will be classified as either a short-term or long-term gain.
- If a gain exists on paper but the asset hasn’t been sold yet, it is considered an unrealized gain.
How Realized Gains Work
Realized gains and unrealized gains differ significantly. Realized gains come into existence when an existing position is sold for more than the purchase price. Conversely, an unrealized (“paper”) gain refers to a profit that hasn’t been realized yet.
Realized gains result in taxable events, but unrealized gains typically stay untaxed. These gains add to the originally reported book value of an asset at the time of purchase. Such gains can occur with all types of assets and investments held by a business.
Balance Sheet Elimination
Realized gains may arise from the sale of an asset when a company opts to remove it from the balance sheet. Asset sales can happen for various reasons and are reported on the financial statements during the period the sale takes place.
Businesses make sure assets are sold at fair market value or arm’s length price. This ensures proper asset valuation in the market and considers whether the asset is sold to a related or unrelated party.
When an asset is sold, a realized profit is gained, raising the company’s current assets and generating a gain from the sale. However, this profit usually results in additional taxable income. This is a typical drawback of converting an unrealized “paper” gain into a realized gain.
Typically, businesses don’t incur any tax until a tangible gain happens.
Realized vs. Unrealized Gains
While realized gains are actualized upon the sale of an asset, an unrealized gain is potential profit on paper, resulting from an investment that has increased in value but hasn’t been sold yet. A gain becomes realized once the asset is sold.
Unrealized gains generally suggest the investor believes in higher future gains; otherwise, they would sell and recognize the existing profit. Moreover, holding an investment for a longer time can reduce the tax burden on the gain.
For instance, an investor who holds a stock for more than one year benefits from a reduced long-term capital gains tax rate. Furthermore, to shift the tax burden to another tax year, an investor might sell the stock in January of the next year instead of the current year.
Investors should also distinguish between realized gains and realized income. Realized income refers to earned and received income such as wages, interest, or dividend payments.
Related Terms: unrealized gain, capital gains tax, book value, balance sheet, financial statements.
References
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
