What is an Unrealized Loss?
An unrealized loss is a form of “paper” loss resulting from holding an asset that has decreased in price but not yet sold. Investors might let a loss remain unrealized in hopes that the asset will rebound, allowing them to either break even or make a marginal profit. For tax purposes, losses must be realized before they can be used to offset capital gains.
Unrealized losses contrast with realized gains and losses.
Key Takeaways
- Unrealized losses occur when asset values drop but are not yet sold.
- These losses only become realized once the asset is sold at a lower value.
- Depending on the type of security, unrealized losses may or may not affect a firm’s accounting.
- For tax purposes, losses are only recognized when realized.
Understanding Unrealized Losses
An unrealized loss happens when the value of a held investment decreases, but the entity has not completed the transaction. For example, the shares in our earlier example remain unsold, and the loss takes effect only after the sale. If the investment recoups in value, the unrealized loss might be erased or transformed into a profit.
Unrealized losses can be calculated from the date assets were acquired to their most recent market value or for specific periods when the value dips below previous valuations.
Selling an unprofitable asset, thus turning an unrealized loss into a realized one, might be a choice to prevent further degradation of the portfolio’s value. This might occur when recovery seems unlikely. The loss may be mitigated if other profitable holdings in a diversified portfolio cover these unrealized losses.
Holding unrealized losses can psychologically impact investors more than gains as they anticipate a rebound, sometimes taking additional risks in the hope of recouping losses, a behavior known as the disposition effect.
Unrealized Losses vs. Unrealized Gains
The opposite of an unrealized loss is an unrealized gain, occurring when a held asset increases in value. Like losses, gains are only realized when the asset is sold for a profit.
Unrealized Losses in Accounting
In accounting, the treatment of unrealized losses varies:
- Held-to-maturity Securities: No net effect on finances and often not recorded in financial statements, though they might be noted.
- Trading Securities: Recorded at fair value in financial statements because their value can affect a firm’s profits or losses, impacting earnings per share but not affecting cash flow neutral.
- Available-for-sale Securities: Recorded at fair value and listed as assets in financial statements.
Tax Consequences
Called “paper” losses because they are significant for taxes only when realized. Generally, capital gains are taxed only when realized; similarly, capital losses are deducted only when realized.
Unrealized losses can impact tax burden if realized, used to offset both current and future capital gains. Even without capital gains, a capital loss might offset regular income within permitted limits.
Example of an Unrealized Loss
Assume an investor purchased 1,000 shares of Widget Co. at $10 each. If the stock price drops to $6, the investor faces an unrealized loss of $4,000. Should the stock rebound to $8, and the investor sells, the realized loss would amount to $2,000.
For tax purposes, the $4,000 unrealized loss holds little immediate significance compared to the $2,000 realized loss.
Related Terms: unrealized gain, realized gain, realized loss, capital gains, fair value.
