Unrealized gains are one of the most powerful tools in becoming rich, and it is one of the reason why some some never pay any taxes. It’s the reason that some investors, can continually compound all of the money they have invested, unlike most, who pay taxes and start the next year with less, only to have to gain to get back where that left off before paying taxes. Unrealized gains are also so often misunderstood. Most people think you will have to realize them eventually, and the truth is, not necessarily. You can get value out of the assets, without having to realize them. And in estate planning, the cost basis of unrealized gains can be completely reset, without ever selling a thing.
First, what is an unrealized gain?
An unrealized gain is a profit that exists on paper, resulting from an investment. It is a profitable position that has yet to be sold in return for cash, such as a stock position that has increased in capital gains but still remains open. A gain becomes realized once the position is closed for a profit.
In other words, you buy an asset, it appreciates in value. You have a gain in asset value, but it’s unrealized, because you haven’t sold. The moment you sell it, the gain is realized. Once you realize a gain by selling the asset, you now have to pay taxes on it, for that tax year.
Here’s why it’s a huge deal.
The investors that understand and utilized unrealized gains, will be far ahead of those who don’t and are consistently paying taxes along the way. It doesn’t mean that paying taxes is bad, and should be avoided at all costs. It means, that if it possible, consider that you may be able to avoid taxation, and letting your assets grow pre-tax, is much better than growing assets post-tax.
Let’s compare a day trader to a long-term investor for example.
YEAR 1: Say both people start with $100. Their stock portfolios both gain 30% in one year. At the end of the year, they both have $130, with a $30 gain. Since the day trader is buying and selling, he has a realized short term gain of $30. The long term investor, bought and never sold, they had an unrealized gain of $30.
YEAR 2: The day trader must pay taxes, let’s say ~33%. So their $30 realized gain is taxed $10, and is now worth $20 after tax. So on year 2 the day trader starts with $120. The long term investor, never sold, has no gains, and starts year 2 off with their full amount of money $130. Now let’s say again, they both increase their portfolio values by another 30%.
Day Trader: $120 + 30% gain = $156 (gain of $36)
Long Term Investor: $130 + 30% gain = $169 (gain of $39)
Now let’s assume, that every year moving forward, the day trader keeps paying a 33% tax on their gain, the long term investor pays nothing, because they never realized a gain, and they each continue to grow their portfolios by 30% each year, for 30 years.
Day Trader’s portfolio would be worth $619.
Long-Term Investor’s: $1,379
Day Trader’s: $3,834
Long Term Investor’s: $19,005
Day Trader’s: $23,744
- taxes paid so far: $11,820
- unrealized gains: $0
Long Term Investor’s: $262,000
- taxes paid so far: $0
- unrealized gains: $261,900
Here’s what that looks like in a table:
First, the day trader.
Now the long-term investor:
The numbers are staggering, and speak for themselves. This was just off an initial investment of $100.
Now wait, you might be saying, 30% is unrealistic to gain each year, and the long term investor still has to pay those gains later on. Hold on.
What’s important to understand here is the big picture, the big concept. Don’t get too caught up in the little details. First you can now clearly see that there is a big deal with starting each year off with 100% of your initial capital, and not paying taxes each year. It doesn’t matter if we reduce the gain amount to 5 or 10%, regardless, the person who defers their gains, and taxes will ultimately be better off if they get the same rate of return that someone who is constantly paying taxes each year and starting out with less. Compound interest is one of the most powerful forces in the world.
What you’re seeing, is the power of unrealized gains, and why it pays to think and invest long term.
Now let’s talk about those gains, as most will certainly ask about that, and argue you still have to pay taxes on it, so maybe it’s not that much better.
Worst case, if were the long-term investor, and later you did realize all of your gains and pay taxes on the last amount (20% as of 2018). You would still be way ahead of the day trader. First because, you’re portfolio value is obviously higher, and your net outcome after taxes would be way more. Second, you’d also be paying at a reduced long-term capital gain rate, and be taxed at the lower 20% (for 2018) tax rate, compared to ordinary earned income rates, which can go near 40% for federal.
But you can get value out of unrealized gains, without having to realize them.
The super rich know, that lower taxation on unrealized gains is just one of the benefits to having long term investments. While yes, you could pay your 20% tax, even better is to get value out of your investments without paying any taxes at all.
One method is simply borrowing against your assets. In stocks, you can borrow on Margin, against your stocks. In the example above, your stocks may be worth $262,000 as the long-term investor, you could easily borrow $30k against it, and use it however you like, without even paying taxes on that. You can get the value out of your assets without paying taxes.
Now a caveat of course, you have to pay deductible interest, and margin on stocks has risks. If the stock value goes down, you may be forced to do a margin call and put that money back in, but that’s besides the point. The point is, you can borrow against your assets, getting value without paying taxes.
It keeps getting better. Now that’s just a stock example, in real estate it’s even better. If you buy a property, it appreciates in value, you can borrow against the asset, and get a long term 30-year fix on it. You deduct the interest, and can use the money to purchase additional assets. Better yet, unlike a margin call, the banks generally don’t have anything like that, and it’s a lot less risky way to get value out of your buildings.
In addition, in real estate you can sell your assets, without realizing your gains if you do a 1031 exchange. A 1031 exchange allows you to sell your asset, and purchase a larger property, if you do this, the IRS will allow you to defer your gains and roll in your low cost basis into the next building. Essentially allowing you to sell your asset, get a new one, without ever paying any taxes! Even better yet, as real estate investors you start an entirely new depreciation schedule.
So what are we going to do with those unrealized gains, eventually we must pay them right? Not necessarily, only if you realized the gains, without doing an exchange will you have to pay taxes on it. If you never sell it, you never have to pay gains on it, and you can defer it until you die. Borrowing against your assets for as long as you want, avoiding the taxation, and letting your portfolio grow every year, at it’s full pre-tax value.
Finally when you die, if you give your assets to your future hiers, they inherit the assets with a stepped up basis!
What that means is, they inherit it as of today’s market price. In the example of the long-term stock investor, who after 30 years has $262,000 in stock value, with a original cost basis of $100, if they sold, they would have a gain of $261,900.
But if they let their kids inherit it at death, the kids would receive the assets with a cost basis of $262,000. So if they they were to sell their $262,000 worth of stock tomorrow, because their cost basis was $262,000 they would have 0 gains on the sale….
This is is the power of unrealized gains. You can compound your money faster. You can get value out of your assets without realizes gains. And later in life, you can give away your assets at death, with a stepped up basis, and they never have to realize any of the gains. (accurate as of 2018).