When a product or investment is sold, the seller must realize a gain or loss from the transaction. The actual sale or transaction will trigger the gain or loss realized. In effect, the receipt of cash sets the threshold for a ‘REALIZED’ amount. Unrealized gains or losses are potential i.e. on paper transactions.
A common business unrealized gain is when a merchant buys inventory and plans to sell this inventory for a higher amount. The difference is unrealized. There has been no exchange of value between the merchant as the seller and some buyer.
However, it is never this simple. We all sell different products or investments and so we’ll need to explore this business terminology a little further.
To make matters worse, there is another authority that has their own definition of realized gains or losses. You got it, our friends or nemesis at the Internal Revenue Service. In this article, the business aspect and how the IRS looks at this concept are explained. The key is that you need to understand the terminology and how to use them in the correct context.
The primary mechanism to realize a gain or loss is a physical transaction between two parties. The seller subtracts his cost from the sales price. If positive, it is a gain. If cost is in excess of the sales price, then the seller has a realized loss.
If the product sits on the shelf for X dollars and the seller purchased the product for X-$5, then the seller has an unrealized gain of $5. But a lot of things can happen between now and the actual transaction moment. The buyer may negotiate the sales price downward reducing the realized gain or it could sit there for months and nothing happens. The product could fall off the shelf and get dented thereby reducing the value and so on. The product may become outdated.
Now in general, your average business operation doesn’t talk about the unrealized (potential) gain because there are too many variables involved.
Where does the term ‘unrealized gain’ come from and why do we hear so many people talk about this? Well, the term is mostly used as the level of confidence increases that the product or investment will sell at the market price. The best example is the stock market. If you bought your shares of XYZ Company (a Fortune 500 Company) for $8 per share some many months ago and now the selling price is $12 per share, you have an unrealized gain of $4 per share. Why? Because there is a lot of confidence in the selling price because public stock sales of Fortune 500 companies are traded by the second. The price change from this moment to the next will be minimal if any at all. As the holder of the shares, you can rely on the selling price as the going value and therefore state you have an unrealized gain of $4 per share.
As the stocks head into the ‘Over the Counter’ market, the confidence level decreases. Many shareholders don’t give a lot of credence to the sale price and will shy away from using the term ‘unrealized gain’.
The following are examples of items where there is a high confidence of the sales price and thus holders of these items tend to use the term ‘Unrealized Gain’ or ‘Unrealized Loss’ when discussing the potential difference between sales price and cost:
- Precious Metals (Gold, Silver, Platinum)
- Precious Stones
- Energy Resources (Oil, Natural Gas, Coal)
- Some Insurance Instruments (Annuities & Whole Life)
Just as there are many items with a high level of confidence, there are also many marginal items and sometimes owners of these items will use the ‘Unrealized’ term to describe the potential in their purchase. Overall, I don’t endorse this usage at this point because the risks are increasing and the variables involved are getting more complicated to get the item/investment to market. I’m sure you have heard some people talk about having an unrealized gain or loss in these items:
- Real Estate – this is one of those debatable issues, but the last 5 years should be ample evidence that real estate is no longer a high confidence item
- Rare Items (Collectibles, Signatures, Coins etc.)
- Trademarks, Patents, Copyrights
- Databases of Information
- Small Businesses
Now we get into the much higher risk items and any businessman that talks about his ‘Unrealized Gain’ in these items, should not be in business. The risks and outside factors affect the selling price quickly. Therefore, these items do not have any unrealized potential. OK, you could state that you have an unrealized loss in them because you could just throw them in the trash and record the loss. These items include:
- Consumer Products
- Raw Resources (other than Energy Resources)
Note that the term ‘Unrealized’ should only be used in business when discussing commonly traded items on some form of an exchange. Stocks, Bonds, Precious Metals and Commodities are traded on exchanges. Insurance instruments are based on those same investments. Energy resources are also available in the open market via exchanges. Land and Precious Stones are not openly traded on any exchange. However, raw land is not as volatile as developed real estate. In addition raw land tends towards a higher level of confidence in maintaining its value. Precious stones are traded within a private market and because of the rarity of these stones; they are able to maintain their value.
The Internal Revenue Service takes a different perspective in using the terms ‘Unrealized and Realized Gains or Losses’.
Internal Revenue Service Usage
It is rare for the IRS to use the term ‘Unrealized’ when talking about gains or losses. They really focus only on the term ‘Realized’ thus avoiding any marginal discussion of some kind of potential. This is founded in one of the tenets of the tax code. It is referred to as ‘Wherewithal to Pay’. Our tax code requires you to pay taxes on what actually happens and not on what may happen. When the sale occurs, cash is exchanged. Therefore the taxpayer (seller) has the ability (wherewithal) to pay any tax due on the gain realized.
The usage of ‘Unrealized’ is found in some complicated business transactions whereby the taxpayers are swapping or exchanging one asset with a built in gain for another asset without any gain between businesses. Because the businesses are trying to avoid any tax, the Internal Revenue Service requires the taxpayer to recognize the ‘Unrealized Gain’ as income. This is a rare situation and for most of the readers, you’ll never come across this scenario. Suffice it to say, the IRS does not use the term ‘Unrealized’.
The IRS places a lot of emphasis on the basis of the asset sold to determine any gain or loss. Basis is not a part of this article. I am only using the term ‘cost’ to keep it simple and understandable for the novice businessman. Later articles will get into the slightly more complicated term of basis.
Summary – Realized and Unrealized Gains
Only in the business world do we use the term ‘Unrealized’. For the purpose of taxation, it is not a used term. In the world of taxes, the government uses the term ‘Realized’ to describe gains or losses.
As a businessman, you should only use the ‘Unrealized’ term when discussing high confidence investments as to the potential gain or loss involved. For any marginal areas, you should resort to using the term ‘Potential’ based on existing known. Remember, gains exist when you sell the item for more than the cost, losses occur when cost exceeds the selling price. Act on Knowledge.