Thursday, April 15, 2010

Realized Versus Unrealized Gains and Losses....written by Greg Gann

A client recently was looking for clarification when reviewing the 1099 for her investment account before presenting it to her accountant. She couldn’t quite comprehend how her account could have had such gains while the 1099 was reporting so many losses. I used a metaphor to explain the difference between realized and unrealized gains and losses that she found helpful. This got me thinking that there are probably plenty other clients who might appreciate and benefit from the same discussion.

As you know, I am an active investment manager. I have no objection to holding onto investments indefinitely. However, if an investment loses value over a stipulated level, I am programmed to sell before the losses become intolerable. This is because to quote the famous economist, John Maynard Keynes, “trends can continue longer than any of us can stay solvent.” I am also not afraid to sell an investment that has had good growth once that growth trend reverses to preserve embedded gains. Most people acknowledge that they have no problems acquiring investments. Their frustration is that they did not have a game plan to sell, and especially during rough market periods, this inertia cost them dearly.

The 1099 documents investments which were sold in a tax year to determine if there was a long-term or short-term gain or loss that would have tax implications. The 1099 does not summarize account values. It only relates to sales of investments within the year. The motto by which prudent investors should live is to let your winners run and to cut your losers short. Just as even the most outstanding baseball player strikes out with greater frequency than he hits home runs, so too investment gains come from singles, doubles, and the occasional home run. Investment gains also come from cutting losers short. When an investment is sold at a loss, that loss is reported on the 1099 tax form. This is a realized loss. When an investment is sold for more than its purchase cost, this is reported as a realized gain. However, investments that have appreciated in value, but have not yet been sold have unrealized gains. Because investments which have unrealized gains have not yet been sold, they do not appear on the 1099 tax form. The analogy I used to clarify this distinction is home equity. Let’s say we own a house for which we originally paid $ 100,000. If the house today is worth $500,000, but we still own it, then we have unrealized earnings (equity) in the house of $ 400,000. However, we do not get a 1099 tax form for that equity, nor do we owe taxes on the gain if we have not sold the house and realized the gain in this tax year. If let’s say there were a dilapidated building on the property that we sold for a loss, then that loss would have tax relevance.

The gains in your investment account are indicated on summary statements, and the value on these statements is net of all losses that may have been realized from selling other investments. The point is that the 1099 shows realized gains and losses, but for account valuation purposes, we really need to pay greater attention to the unrealized gains and losses, similar to home equity. We might have losses reported for tax purposes, but gains that are more relevant, but for which there is no tax consequence in a particular tax year. And, this entire discussion only applies to taxable accounts. It is not pertinent to retirement or other tax-advantaged accounts.

Hopefully that clarifies how we can have “losses” in years in which we have gains.

The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.