There are two types of gains and losses on an investment: realized and unrealized.
Realized Returns
A realized return is the difference between the sale price of the asset and the purchase price. For example, if a stock is bought for $5 and sold for $7, there is a realized gain of $2. If the stock is not sold, there is an unrealized gain of $2.
The difference between realized and unrealized returns is that realized returns result from the actual sale of the asset, while unrealized returns occur when the asset is not sold and result from a change in the market price. These returns appear separately on the firm's financial statements, and have different tax implications as well.
Returns are reported each reporting period when the financial statements are created. Realized gains involve a set transaction, so determining their value is relatively straight-forward. Unrealized gains/losses are usually calculated by the market value at the end of the reporting period (mark-to-market). For example, unrealized gains/losses on a stock are calculated using the price at the close of the market at the end of the period. This is not the only method for calculating the change in value of an asset, however.
Unrealized Returns
Unrealized gains are also confined only to the financial period for which the statement is prepared. For example, suppose a firm purchased 1,000 shares at $10 per share on January 1, 2012. The firm uses mark-to-market valuation. On December 31, 2012, the price is $12 per share. By December 31, 2013 the price has risen again to $15. The shares are not sold. There is a total unrealized gain of $5,000, but it is composed of a $2,000 unrealized gain in 2012 and a $3,000 unrealized gain reported in 2013.
In terms of taxation, only realized gains are taxed . While realized returns are reported on the income statement (and affect the cash flow statement) and unrealized returns are reported on the balance sheet, only realized returns have tax implications.
IRS: The IRS is responsible for interpreting and enforcing tax legislation passed by Congress. The IRS taxes only realized returns, though financial reports must also include unrealized returns on the balance sheet.
