An investment can increase substantially in value without creating an immediate federal income tax bill. In a taxable account, gains generally aren’t taxed until the asset is sold. That tax deferral can be valuable, but when and how the gain is eventually realized can have a significant effect on the rate you pay. Holding period, income level and the size of the gain can all influence the eventual tax treatment.
A financial advisor can help you evaluate when to realize investment gains and how a sale could affect your taxes, portfolio allocation and broader financial plan.
How Unrealized Gains Are Taxed
An unrealized gain is the increase in an investment’s value while you still own it. For example, if you purchase stock for $50,000 and its market value rises to $80,000, you have a $30,000 unrealized gain. Your cost basis generally starts with what you paid for the investment. Certain transactions and adjustments, however, can increase or decrease that basis over time.
Under current federal tax rules, that $30,000 increase generally does not create a capital gains tax liability simply because the investment became more valuable. Capital gains typically come into play when an investor sells or otherwise disposes of a capital asset for more than its adjusted basis. In other words, the gain generally remains unrealized, and therefore untaxed as a capital gain, until there is a taxable transaction.
This does not mean an investment necessarily produces no taxable income while you own it. A stock could pay taxable dividends even though you never sell the shares. Meanwhile, bonds, savings products and other investments can generate taxable interest. Those payments are separate from the unrealized appreciation in the asset’s market price, and you may need to report them as income in the year you receive them.
That distinction can make unrealized gains valuable from a tax-planning perspective. An investor may be able to hold an appreciating asset for years without paying federal capital gains tax on the increase in value. As a result, more of their money can remain invested. Taxes generally become relevant once an investor sells some or all of those appreciated shares.
Deferring Tax on an Unrealized Gain
Consider an investor who puts $100,000 into a stock investment. Several years later, the shares are worth $175,000, giving the investor a $75,000 unrealized gain.
As long as the investor continues holding the shares, the $75,000 increase in value generally does not produce capital gains tax by itself. If the investor later sells all of the shares for $175,000, however, the $75,000 difference between the sale proceeds and the $100,000 basis generally becomes a realized capital gain that may be taxable.
Deferral can give the investor some control over when the taxable event occurs. Instead of selling immediately after an investment appreciates, for example, an investor may decide to hold the asset until a future year when income is lower or other tax circumstances are more favorable. Market risk remains important, however, because there is no guarantee that an investment will retain its current value while the investor waits.
When Tax Treatment Can Be More Favorable
One of the biggest factors affecting the eventual tax treatment of an unrealized gain is how long the investment is held. An asset generally produces a short-term capital gain when it is held for one year or less and a long-term gain when it is held for more than one year. Long-term capital gains are generally subject to preferential federal rates of 0%, 15% or 20%, depending on filing status and taxable income. 1 Meanwhile, ordinary income tax rates generally apply to short-term gains.
The ability to decide when to sell can therefore create planning opportunities. Someone approaching retirement, taking a career break or otherwise expecting a lower-income year might choose to realize some appreciated investments when their taxable income is lower. Depending on their overall tax situation, this could result in more of their long-term gains falling into a lower capital gains bracket.
Another potentially favorable result can occur when a person inherits appreciated capital assets. In most cases, the basis of inherited property generally becomes its fair market value on the owner’s date of death. This basis adjustment can reduce or eliminate income tax on the appreciation that occurred during the deceased owner’s lifetime.
For example, imagine someone bought stock for $100,000 that was worth $400,000 when they died. If an heir receives a $400,000 basis and sells the shares shortly afterward for approximately that amount, there may be little or no capital gain attributable to the original owner’s $300,000 of appreciation. That treatment can make holding certain highly appreciated assets until death more tax-efficient in some estate planning situations. Still, estate taxes and other considerations may also be relevant.
Long-Term vs. Short-Term Tax Treatment
Holding periods can substantially change the federal tax cost of selling an appreciated investment. Consider a hypothetical investor, filing single, who realizes a $50,000 capital gain and falls within the 24% ordinary income tax bracket.
| Gain | Holding Period | Tax Treatment | Assumed Federal Tax Rate | Estimated Federal Tax |
|---|---|---|---|---|
| $50,000 | One year or less | Short-term capital gain | 24% | $12,000 |
| $50,000 | More than one year | Long-term capital gain | 15% | $7,500 |
Under these assumptions, waiting until the investment qualifies for long-term treatment reduces the estimated federal tax by $4,500 ($12,000 – $7,500). Of course, this is a simplified example. Actual capital gains rates depend on taxable income, filing status and other circumstances. Further, portions of a gain can potentially be taxed at different rates.
As we discussed above, holding an investment merely to qualify for a lower tax rate also involves a tradeoff. An asset could decline significantly during the additional holding period, potentially wiping out more value than the tax savings. Investment fundamentals, diversification needs and risk tolerance can therefore be just as important as taxes when determining whether to sell.
When Unrealized Gains Can Lead to Less Favorable Tax Results
Deferring a gain does not guarantee better tax treatment. An investment that appreciates substantially over many years can eventually create a large realized gain when it is sold. Realizing a large amount of gains in a single tax year can push some long-term capital gains into a higher rate bracket, potentially increasing the investor’s overall federal tax bill.
Higher-income taxpayers may also face the 3.8% net investment income tax (NIIT). The tax generally applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds the applicable statutory threshold. Capital gains, dividends and interest are typically included in net investment income. Because of this, realizing a large gain could increase exposure to the NIIT.
Investors should view taxes as one part of a broader investment decision, rather than the only reason to hold or sell an asset. A financial advisor or tax professional can help evaluate when to realize gains, identify which appreciated assets may make sense to sell and determine how those transactions could affect capital gains rates, investment income taxes and an investor’s broader financial strategy.
Bottom Line
Unrealized gains generally are not subject to federal capital gains tax until the sale of an investment, giving investors some control over when a taxable event occurs. Holding assets for more than one year can qualify gains for lower long-term capital gains rates, while inherited assets may receive a basis adjustment that reduces taxable appreciation. However, large sales can still trigger higher capital gains rates or the 3.8% net investment income tax. As a result, timing, holding period and overall income should all factor into the decision to realize gains.
Tax Planning Tips
- For individuals managing significant equity investments or coordinating multiple income sources, working with a financial advisor may provide valuable insight into tax-aware equity planning strategies. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s tax return calculator has updated brackets and rates to help you estimate your next refund or balance.
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