What are realized and unrealized gains and losses? Table of Contents
- What is the difference between realized and unrealized profits?
- What is realized profit or loss?
- What is unrealized profit or loss?
- How to Calculate Cryptocurrency Unrealized P&L
- Realized Bitcoin vs. Unrealized Bitcoin
- HODL (hold on for dear life)
- Active trading
- Examples of Realized and Unrealized Profits
- Conclusion
In the end, it is profit and loss that investors look at when trading financial assets. On paper it may be a profit, but if you don’t actually sell the investment, the profit isn’t real. This is why you need to learn the concepts of realized and unrealized gains and losses.
When the cryptocurrency you own is recognized for its value, you should not sell it until the potential profit is realized. On the one hand, there is a saying on Wall Street that ” bulls and bears make money, but pigs are cooked and eaten “. In other words, don’t be greedy. Good advice. But it is easy to say and difficult to do in practice.
In this guide, we will learn how to differentiate between realized and unrealized P&L and plan the next investment based on the result.
What is the difference between realized and unrealized profits?
When cryptocurrency investors sell their assets, they get a loss/profit, which is called a realized loss/profit. Likewise, any gains or losses on cryptocurrency assets are considered unrealized gains/losses.
Investors typically hold unrealized gains and losses for future price increases. When the expected profit is achieved, the investment can be easily turned into cash. At this time, unrealized profit is converted into realized profit.
When comparing crypto-to-fiat to crypto-to-crypto trading, the transaction is the same as far as the profit and loss is generated. However, the most difficult part of trading cryptocurrency is knowing when to cash out.
Now, let’s dive into the details of realized and unrealized gains and losses and how important they are to traders.
What is realized profit or loss?
Realized profit or loss refers to the profit or loss accrued from the sale of financial products. When investors buy a stock or commodity, they pay fiat money for that particular commodity. Later, when investors sell the instrument, they usually make a profit or a loss and convert the instrument back to fiat.
The most important part of realized profits is that you may be subject to capital gains tax depending on your jurisdiction. When you sell a financial product to make a profit, you have to pay taxes on it. Conversely, if you make a loss on the sale of an asset, you can deduct capital gains tax from your tax.
For example, if you buy a house worth $100,000 and sell it for $120,000 after a set period of time, you will have a realized profit of $20,000. This realized profit is subject to capital gains tax.
On the other hand, if you sold the same house for $80,000, you would lose $20,000. In this case, capital gains tax can be reduced when calculating income tax.
When you buy cryptocurrency assets in financial transactions, profit and loss due to price fluctuations are inevitable. These price changes are not taxable until you sell the cryptocurrency and achieve a realized profit or loss.
What is unrealized profit or loss?
Unrealized gain or loss is a variable gain or loss achieved prior to the sale of financial instruments. At the same time as purchasing a financial product, profit or loss occurs due to price fluctuations. The gain or loss from this price change is unrealized until the financial instrument is sold.
The unrealized gain or loss is the potential gain or loss that an investor could obtain by selling all investments. In other words, the value of an asset is expected to give a profit or loss, but if there is no inflow/outflow from that asset, it is an unrealized profit or loss.
Calculating unrealized P&L is simple. Investors can calculate unrealized P&L by comparing the present market value with past value. If the current market value is high, it is an unrealized profit; if it is low, it is an unrealized loss.
Investing in Bitcoin is a perfect example of unrealized profit or loss for us. For example, if you buy 1 BTC for $20,000 and put your investment on hold until that BTC reaches $60,000, you have made a profit of $40,000. This profit has not been realized because you have not yet sold your BTC. Once you sell your invested BTC to get money and make a profit, this is your Realized Profit/Realized Loss.
The formula for calculating unrealized P&L can be simplified as follows:
Present Market Value – Past Value = unrealized profit/(unrealized loss)
If the value obtained from this calculation is positive, it is an unrealized profit. If it is negative, it is an unrealized loss.
How to Calculate Cryptocurrency Unrealized P&L
Unlike traditional investments, cryptocurrencies are complex with two buying methods. The first way is to buy cryptocurrencies with fiat currency, and the second way is to buy cryptocurrencies with cryptocurrencies.
In the existing investment model, there is no peer-to-peer (P2P), so the transaction process is simple. Investors typically buy stocks from brokerage firms based on their future potential. The whole process is relatively simple. You pay a broker cash to buy stocks like Facebook stock. Once the stock increases in value, you will have an unrealized profit, and if you sell the stock for a higher value, you will earn a realized profit.
A similar scenario applies to the cryptocurrency market. For example, let’s say you bought Ether for $100. You decide to put your investment on hold until its value reaches the $3,000 level, and then cash out the profit at that level. Once you exchange Ether for fiat, you get a realized profit of $2,900 ($3000 – $100).
What if you had bitcoins in your wallet and bought other cryptocurrencies with those bitcoins?
Exchanging one cryptocurrency for another is also a taxable profit. For example, let’s say you bought $50,000 worth of Bitcoin and exchanged BTC for Ether. Since then, the value of Ether has risen to $90,000. In this case, the realized profit would be $90,000 minus $50,000, which would be $40,000.
Realized Bitcoin vs. Unrealized Bitcoin
Cryptocurrency realized and unrealized gains are different from traditional financial markets, especially for Bitcoin.
Bitcoin is the most traded cryptocurrency in the world. And it has earned its status as a safe investment. With the recent Bitcoin market cap reaching $1 trillion, Bitcoin is a significant milestone for the cryptocurrency market.
Large-scale retail and institutional involvement in Bitcoin is driven by long-term and short-term capital gains. In addition, investors and another cryptocurrency Altman coin have been bribed, even as Bitcoin or Ethernet Solarium Defy projects and invest in. Therefore, both cryptocurrency-to-cryptocurrency and cryptocurrency-to-fiat transactions will occur. Therefore, the realized or unrealized profit of Bitcoin is different from that of existing assets.
There are generally two investment models for Bitcoin. Buying and holding cryptocurrencies for a long period of time is called HODL, and speculation about short-term price volatility is known as active trading.
Let’s take a closer look at HODL and active trading.
HODL (hold on for dear life)
HODL is often referred to as ‘hold on for dear life in the cryptocurrency market because of the misspelling of “hold”. The term is used especially in bear markets when prices fall but is also used to indicate that investors choose to hold their assets in anticipation of future price increases instead of buying them.
When cryptocurrency prices fall, investors face unrealized losses. However, when HODLers sell cryptocurrency for profit, a realized profit is generated.
Bitcoin’s HODL includes both realized and unrealized gains and losses. Investors must pay capital gains tax on all realized profits they achieve when they do HODL. Failure to accurately calculate the realized profit will affect the tax calculation.
Active trading
The cryptocurrency market does not go up or down straight away. Rather, it moves in a zigzag fashion.
Thus, short-term price volatility creates trading opportunities when trades are active and pay attention to price movements.
For example, if you bought Bitcoin for $10,000 in anticipation of future price appreciation, it will be difficult to reach your target right away. For example, it may fall to a swing low and swing high before it even moves to a target value. Active trading like swing trading is the process of catching these swings, rather than holding trades like HODLers.
In active trading, traders make multiple trades in a swing where every sale is subject to a realized gain. Unlike HODL, calculating the realized P/L from active trades is more complex as the number of transactions increases.
Numerous portfolio trackers and cryptocurrency software programs can help investors manage realized and unrealized gains and losses. Additionally, these tools often help you optimize your taxes. However, you should also be aware of the differences between the capital gains tax rates in each jurisdiction.
Examples of Realized and Unrealized Profits
Now, let’s look at some examples of realized and unrealized profits in the cryptocurrency market.
Adam is an investor who has adopted the Bitcoin Long Term Buy Strategy (HODL). In 2018, he buys 1 Bitcoin for $10,000. In early 2021, Adam discovers that Bitcoin has reached $60,000 and decides to sell it. With Bitcoin reaching the $60,000 level, Adam immediately has an unrealized profit of $50,000.
Later, Adam sells bitcoin. A sell occurs when the price change brings the selling price to $58,000. Thus, Adam earned $48,000 ($58,000 – $10,000) in realized profit. The realized profits are now subject to capital gains tax.
When Adam calculates his income tax, he has to pay tax on his actual income. On the other hand, there was an unrealized profit before selling bitcoin, so no income tax was imposed on it.
Let me give you a second example. Anna is a Bitcoin speculator who only catches short-term price movements. She invests $5,000 in Bitcoin in USDT, and the next day Anna finds out that Ethereum has a higher potential for price appreciation than Bitcoin.
So, she converts $5,000 worth of Bitcoin into Ethereum. However, the situation worsens as the price of Ethereum plummets, and Anna’s investment value drops to $3,000. So Anna loses $2,000 and exchanges Ethereum for Bitcoin.
However, as the cryptocurrency market became unstable, the value of Bitcoin started to decline following Ethereum. Anna’s $3,000 Bitcoin investment has dropped to $2,000, and she withdraws this amount in USD.
Here are two deals Anna made:
- First, Anna bought Ether using BTC and lost $2,000.
- Second, Anna exchanged BTC for USD and lost $1,000.
In the first transaction, Anna exchanged cryptocurrencies, so $2,000 is a realized loss that will affect her income tax. In the second transaction, since Bitcoin was exchanged for fiat currency, Anna can consider $1,000 as a realized loss.
Conclusion
All cryptocurrency or fiat currency exchanges are related to realized or unrealized gains and losses. These gains and losses ultimately affect the increase or decrease in taxable income.
It is often difficult for traders to find the right time to sell their crypto assets. Selling cryptocurrency assets for profit generates a realized profit, but investors will have to pay taxes for this. On the other hand, selling cryptocurrencies with losses may result in realized losses, allowing investors to receive deductions for taxable income.
In this context, the best approach is to hold cryptocurrency assets for a considerable period of time and reduce capital gains tax as much as possible.
In addition, timing is very important in the market as financial markets are highly volatile. Investing always involves risk. Investors need to diversify their portfolios by adding various crypto assets to their portfolios. By doing this, investors will be able to reduce their losses.
Also, you need a strong trading strategy. Investing in financial markets is not a game of guesswork. There must be logic and reason behind every decision.
In addition to striving for continued profitability, investors should also keep realized gains/losses in mind in their tax plans.
(Forex Broker)
Comment by Hans
April 24, 2024
as I am trading here various assets, for me it's the most important feature. i mean, flexibility in tradable markets. i alternate trading styles, meaning that sometimes I trad...