The term “unrealized gains” has been in the news a lot lately and for good reason. Democrats in congress are expected to introduce legislation that would levy a tax on the unrealized gains of the so-called “ultra wealthy”. The reason for the proposed new tax is that the Democrat majority is struggling to find the funding necessary to support President Biden’s social spending plans. They initially tried to raise the necessary funding by proposing an increase in the corporate and individual tax rates. However, this was met with resistance from within their own party namely from Sen. Kyrsten Sinema and Sen. Joe Manchin[i][ii]. The proposed “wealth tax” would only affect the wealthiest 0.0002% of all taxpayers or around 700 Americans.
The good news is that, in all likelihood, the bill will either fail to pass the senate or, if it does, have zero impact on the vast majority of American taxpayers. However, that is not to say that something like this could be passed at some point that would encompass a larger swath of tax paying Americans. Now would be a good time to understand what an unrealized capital gain is and how it differs from realized capital gains.
The term “capital gain” in general refers to the profit that one receives when they sell an asset for more than what they paid for it. This applies to many types of assets including your home, car, boat, real estate property, and investment accounts. By contrast, you can also have a capital loss when you sell an asset for less than the amount that you purchased it for. Capital gains are categorized as either long term or short term depending on how long you have held the asset. Long term capital gains are applicable on assets held for over a year and are taxed at a separate rate that depends on your filling status (single or married filing jointly for example) and your annual income. Short term capital gains apply to assets held for under a year and are taxed at the same rate as your normal employment income.
Whether or not a capital gain is “realized” or “unrealized” is what determines if and when that gain is taxed. In general, capital gains are only taxed when they become realized. A gain is considered realized when the asset in question is sold for a profit. For example, let’s say that you invest some money in a brokerage account for 5 years and it grows by 50%. You then sell the investment and take the cash. In this scenario, you would be required to pay long term capital gains tax on the 50% increase because the gain was realized when you sold the investment.
Unrealized gains are nothing more than the difference between what you paid for an asset and what it is worth today. It is essentially a hypothetical number that states what your realized gain would be if you sold the asset for its current market value. The dollar amount of an unrealized gain fluctuates as the value of your asset changes, whether up or down. For example, let’s say that you bought a piece of real estate for $150,000 and the value rises to $200,000. This would constitute a $50,000 unrealized capital gain, which would become a taxable, realized gain if you sold the property at that market value.
While I am not going to go into here, when you actually pay taxes on a realized gain in an investment account also depends on the type of account. I wrote about this in a blog post back in January, which you can find here. The bottom line is that, while the proposed taxes may not affect you now, it is a good idea to have an understanding of the terms being used in congress. Especially when it could one day play a role in your own finances!
At the time of this writing, I am (not so patiently) awaiting this weekend’s college football matchup between Michigan and Michigan State. In honor of arguably the nation’s most bitter in-state rivalry, here is your song of the week! Go Blue!
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