An unrealized loss, also referred to as a paper loss, occurs when an asset you've bought and are keeping has lost value and is therefore worth less than what you have paid for it. Unrealized losses can occur in stocks, bonds, real estate and in complex financial instruments, such as options and futures. Knowing how to handle such losses in your tax return is critical.
Realized vs. Unrealized Losses
In conventional trades, in which you first purchase and then sell an asset, the gain or loss is unrealized until you complete the sale. However, a trade doesn't always begin with a purchase and finish with a sale. Therefore, the broader rule is that gains or losses associated with "open positions" are unrealized. A position is open until you have terminated the financial commitment and no longer hold an asset, can make a claim on another investor's assets or owe anything. In a short sale, for example, in which you first sell an asset and then purchase it, the position is open until you buy back what you sold.
Futures and Options
Futures are binding agreements to buy or sell something of value on a future date. An investor doesn't really buy a futures contract. Rather, she enters into a futures agreement and can commit to either buy or sell as a result. A typical futures contract can oblige the investor to buy 10 ounces of gold at $1,050 per ounce on January 28. Options, on the other hand, give the holder the right, but not the obligation to buy or sell something of value on a future date. Options can be bought and sold, just like stocks.
Reporting Unrealized Gains or Losses
When filing an individual income tax return, you report only realized gains or losses. All unrealized profits or losses, regardless of source, are ignored for tax purposes. Especially if you have a tax deductible loss, you must close the position before the end of the year to claim the loss. Similarly, a gain that you prefer to go into this year's tax return since you're in a lower tax bracket at the moment, can be reported only if you close the position. Due to this reason, the financial markets tend to be highly active on the last trading day of the year.
Since exercising options isn't mandatory, investors sometimes let options expire without taking any action. The option may, for example, allow the investor to buy silver for $20 an ounce on December 27. If, however, silver costs $19.5 in the open market, there is no point in exercising this option, and the investor would let the option expire by taking no action. Even though she didn't sell the option, the position will be considered closed on December 28. The price paid for the option will be considered a realized loss, since the asset purchased is now worthless and no longer exists.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.