Realized gains and unrealized gains relate to a capital gain made on an asset. Basically a realized gain occurs when you dispose of an asset for a greater value than what you purchased the asset for. An unrealized gain is the hypothetical increase in value of an asset that you still currently hold.
Consider a simple scenario. You buy 100 shares in a company at $10, for a total amount of $1000. The price goes up to $14, and you then sell the 100 shares for $1400. You have made a profit of $400, minus any fees or commissions. This is subject to a capital gains tax, rather than income tax, since you have realized a capital gain. In other words, you made a profit at the point that you sold the shares.
On the other hand, let’s assume that you buy 100 shares and the price goes up to $17 a share from $10. On paper, you have made a profit of $700 at this point. However, you have not made an actual profit – the profit would only come once you sold the shares. Because of this, this is known as an unrealized gain, since you have not realized the profit at this point. Unrealized gains are not subject to capital gains tax – it is only when they become realized gains that the tax man wants his cut.
You can often generate better returns on investments if you avoid realizing gains. Essentially, every time you buy and sell shares, you pay tax on the profits you make. On the other hand, if you hold on to your shares, then you only have to pay tax at the end when you finally unload them. This in turn means that you will generate a higher net return – much in the same way as you do with a tax-deferred retirement savings account such as an IRA, since all your profits are reinvested rather than a portion going back to the IRS.
The US tax structure favors long-term investments. If you buy a stock or other investment, and then sell it within a year, any profits you make will be subject to a tax on short-term capital gains. This is set at the same rate as income tax. For example, if your income tax rate is 25%, then you will also pay 25% short-term capital gains tax as well. However, if you hold onto your investment a year or more, it is subject to long-term capital gains tax – which is lower than the equivalent short-term tax. For instance, if you pay 25% income tax, then you will only pay 15% long-term capital gains tax – a saving of 10%.