What Exactly are Unrealized Capital Gains, Anyway?

This isn’t political

Recently, you may have heard about the idea of taxing unrealized capital gains and wondered what that means. You may have also seen dramatic polarizing coverage of the idea and wondered if it is worth all the fuss (but again, what is it?). In short, yes, it is an important idea and yes, the reactions are going to be strong. After all, a) it is a politically charged idea and b) it is something that has never been tried before.

I have my personal feelings about taxing unrealized capital gains. However, I’m no economist and I doubt you are coming to me for my political views. So, instead of burdening you with rhetoric about why this is or isn’t a good idea, I’m simply going to talk about the idea itself. What are capital gains? What are realized vs unrealized vs recognized gains? How are they taxed normally? Finally, how might this work in real life?

Cap gains, investment income, realized, and recognized.

First let’s take a step back and discuss the different parts of this issue. We’ll break down each part of the idea and bring them together to help paint the overall picture, starting with cost basis and capital gains.

Welcome to the “stock” yard

When explaining the parts of this issue, I like to use the analogy of investors as dairy farmers. To start, let’s imagine three individuals: two investors and one dairy farmer. The first investor buys stocks, the other investor buys bonds, and the dairy farmer buys a young cow.

Cost basis

Whenever a stock or bond is purchased, a cost basis is established. For the sake of our analogy, the farmer will get the same treatment when he purchases the cow.

Simply, cost basis refers to the price paid to acquire the investment. It normally includes any fees or other costs associated with the purchase, but for now we’ll only consider the price paid. For our farmer, let’s say he purchases the cow for $2,000. Therefore, his cost basis for the cow is now $2,000. For the stock investor, let’s say she buys 20 shares of a stock at $100 each. Her cost basis is also $2,000. Finally, let’s imagine the bond investor buying two bonds with a face value of $1,000 each. That investor’s costs basis? You guessed it, $2,000. Both investors and the farmer all have the same cost basis for their investments: $2,000.

(Purchase of livestock for farming can be tax deductible as business expenses, but for the sake of the analogy we will ignore that treatment)

When a cost basis is established for an investment, no taxes are paid. This is because the appropriate taxes have already been levied and paid on the money used (when it was earned). Once the investment is purchased, accounting and record keeping is used to keep track of the cost and any adjustments to the basis. If a cost arises to maintain the ownership of the asset, that is usually added to the basis as well.

For our analogy, both investors and the dairy farmer all carry forward a $2,000 cost basis for their investments with no adjustments.

Capital gains

Capital gain occurs when the value of the investment increases beyond the cost basis. If you purchase an investment for $10 and sell it for $15, then you have $5 in capital gain ($10 cost basis and $5 capital gain). Capital gain represents the change in actual value of the investment itself.

While it’s not common for dairy cows to re-sale for higher values at the end of their lives, let’s imagine the farmer needs to sell the cow early and it is in prime milking years. If they manage to sell the cow at a higher price than they paid for it, then that difference represents capital gain.

When the investment is ultimately sold on the market, any resulting gain is treated as capital gain. That is, the investor receives the profit and is expected to pay capital gains taxes on it. Money received, money taxed.

To recap:

Cost basis = money paid for an investment.

Capital gain = increase in value of the investment beyond the cost basis.

Capital gain tax = happens when the asset is sold for a profit.

Milk, interest, and dividends

When an investor buys a security, just as a farmer buys a cow, they are seeking some form of return or profit. As seen above, this can happen with the increase in value (capital gains), but that isn’t the only way. During ownership of the asset, the investor might also receive periodic payments from time to time. These periodic payments are usually classified as dividends or interest income. Let’s break it down.

Dividends: Typically paid on stocks, dividends are a share of company’s profits. For instance, if an investor owns a share of Coca-Cola, they might receive part of Coca-Cola’s profits in the form of dividend payments.

Interest income: Typically paid on bonds, an investor will receive periodic payments classified as interest income. Since bonds are a form of money lending, the interest payment received represents the interest paid on the loan from the borrower.

In keeping with our analogy, dividends and interest income would be similar to the milk received by the farmer. Periodically, an investor receives payment just as the farmer regularly receives milk from their investment.

Realized and recognized

Dividends and interest income share a common trait. That is, they are both realized in the year in which they are received. They are also usually recognized in the same year as well. These two terms are closely related and can be confusing, so let’s break them down as well.

Realized: Simply, this means that the money is actually received. If the bond investor receives interest payments, then he has “realized” that money. Likewise, if the stock investor receives a dividend payment, she has “realized” it.

Recognized: This refers to when the money is recognized by the IRS for tax purposes. For both interest and dividends, the money is recognized and taxed in the same year they are received.

In my CFP studies, I had a little quote I would say in my head to keep these straight, “I really enjoyed receiving this money. I hope the IRS doesn’t recognize me.”

When an investor receives dividends/interest or the dairy farmer receives and sells milk, taxes are due that year. As mentioned above, money is received (realized) so taxes are due (recognized). Since the investor and farmer both have liquid profits from their investments (pun intended), the IRS now wants their share. This usually isn’t a problem as most investors and business owners are accustomed to this treatment. Since they are actively receiving revenue in that year, paying taxes on their gains usually isn’t a problem. They simply remove a portion of those profits and set it aside to pay the taxes due.

For instance, let’s say the stock investor received $100 in dividends this year, the bond investor received $100 in interest, and the dairy farmer sold $100 worth of milk (again, never mind the expense write offs). For the investors, the brokerage companies can track and report their earnings to the IRS. The farmer will keep track and probably pay some sort of quarterly estimated taxes on his earnings.

So, for these periodic payments, they are said to be both realized and recognized in the same year. Again, money received, money taxed.

When capital gains are recognized

As you can see from the breakdowns above, there is a common theme; money received, money taxed.

But what about taxing unrealized capital gains? That is, what if capital gain tax was levied on capital gain before the investor decides to sell and realize their profit?

This is how it would work.

Let’s return to our investors and farmer. Let’s say they all purchase their investment in 2024. Therefore, on Dec 31, 2024, each of them would record (or appraise) the value of their relative investments. Let’s say each investment had a 10% gain, resulting in a year end investment value of $2,200 for each. $2,000 cost basis and $200 unrealized capital gain.

Under the idea of taxing unrealized gain, the IRS would then come for their share. The $200 capital gain would be taxable in 2024 for each investor. Money not received, money taxed.

This treatment can cause a catch-22 for an investor. If they are fortunate enough to experience gains during the year, they will be forced to either sell part of the investment to pay the taxes or come up with the tax money some other way. This would be inconvenient for the investors and nearly impossible for the farmer. After all, sell a small part of a dairy cow doesn’t sound too lucrative (for the farmer or the cow).

Assumptions

It's difficult to know for sure how this idea would be implemented, but we can make some reasonable assumptions. This isn’t based on any publication. These are my personal assumptions.

Assumption 1: Any taxes paid on unrealized cap gain would increase the cost basis. That is, if each investor paid taxes on their $200 unrealized gain, their new cost basis should be $2,200. This amounts to a tax-as-you-go system that would adjust the cost basis each year, ultimately making the sale of the investment nearly tax free.

Assumption 2: Any unrealized losses (if the investments should go down in value) should be immediately deductible as a capital loss. Currently we’re allowed to claim up to $3,000 a year in realized capital losses against income, but this treatment should make that unlimited.

Assumption 3: This treatment should ignore primary home ownership, personal property, and qualified retirement plans. It’s hard to imagine the government taxing accounts that are specifically designed to avoid taxes and, just like the farmer selling a part of his cow, it’s hard to imagine selling a room off your home to pay unrealized gain tax.

Good idea, bad idea

The proponents of this plan say it will only apply to the ultra-wealthy. I suppose this is intended to make it more palatable to most people or convince them they don’t need to worry about it.

For us regular folks, it’s important to understand the various parts of the issue and decide for ourselves. If it’s a good idea, then why limit it to only the super wealthy? Likewise, if it isn’t a good idea, then it’s probably a bad idea for everyone regardless of wealth.

That’s for you to realize.