At the end of the day, profit and loss are what investors are looking into when trading any financial assets. An investment may be profitable on paper, but the profits aren’t real if you never actually sell your investment. That’s precisely why you must familiarize yourself with the concept of realized and unrealized gains and losses.
When a cryptocurrency that you own appreciates in value, the last thing you want is to sell when there’s a potential gain. On the flip side, there’s a saying in Wallet Street — “Bulls make money, bears make money, and pigs get slaughtered.” In other words, never be greedy! This is good advice but it’s easier said than done.
In this guide, you’ll learn how to differentiate gains and losses that are realized or unrealized to plan your next move based on investment results.
How Are Realized Profits Different From Unrealized Profits?
When a crypto investor sells his asset, he will gain a loss/profit, which is known as realized loss/profit. Likewise, any running profit or loss on the crypto asset is considered an unrealized profit/gain.
Typically, investors hold their unrealized gain or loss for future price appreciation. When the anticipated profit is achieved, they can easily cash out the investment. At that time, the unrealized profit will then be converted to a realized profit.
In short, you don’t gain anything from your investment until you sell your assets. Realized profit becomes a matter of consideration as soon as you sell your asset. Therefore, it is vital to understand the total amount of profit and loss if you want to be a successful cryptocurrency investor.
When comparing crypto-to-fiat and crypto-to-crypto trading, the transactions work the same when it comes to how profits and losses are made. However, the hardest part about crypto trading is knowing when to cash out.
In the following section, we will further explore the details of realized and unrealized gains and losses and their importance for traders.
What Are Realized Gains and Losses?
Realized gains and losses are profit/loss achieved when you sell any financial instrument. When investors buy a share or commodity, they pay fiat currencies for buying that particular instrument. Later on, when they sell it, they usually convert the instrument to fiat currency again with a profit/loss.
The most important aspect of realized profit is that it can be subject to capital gains tax, depending on the jurisdiction. When you sell any financial instrument for a profit, you have to pay taxes for it. Conversely, if you take a loss on selling any assets, you can deduct the capital gains tax from your tax obligation.
For example, if you buy a house that is valued at $100,000 and sell it for $120,000 after a certain period, you will make $20,000 of realized gain. This realized gain is subject to capital gains tax.
On the other hand, if you sell the same house for $80,000, you will take a $20,000 loss. In that case, you have a chance to reduce the capital gains tax from your income tax calculation.
If you buy any crypto asset in financial trading, you will inevitably have profit/loss based on its price fluctuation. This price fluctuation is not taxable until you sell the cryptocurrency and achieve realized gains or losses.
What Are Unrealized Gains and Losses?
Unrealized gains or losses are floating profit/loss achieved before selling any financial instrument. As soon as an investor buys a financial instrument, there will be a profit/loss due to the price fluctuation. Profit/loss from this price fluctuation is unrealized profit/loss until the financial instrument is sold.
The unrealized gain/loss is the potential profit/loss that an investor would gain from selling any investment. In other words, if an asset’s value is projected to make a profit/loss, but there is no cash inflow/outflow from it, it is an unrealized gain/loss.
The method for calculating unrealized gain/loss is straightforward. Investors compare the current market value with the historical value to calculate the unrealized gain/loss. If the current value is higher it is an unrealized gain, and if lower, it is a loss.
Investment in Bitcoin gives us a perfect example of unrealized gain/loss. For example, if you buy 1 BTC for $20,000 and hold your investment until the BTC price reaches $60,000, you’ve made a $40,000 profit. This profit is unrealized because you haven’t yet sold your investment. Once you do sell and receive the money invested, with a profit, it becomes a realized gain/loss.
We can simplify the formula for calculating unrealized gain/loss as follows:
Current Market Value − Historical Value = Unrealized Gain/(Unrealized loss)
If the value obtained by this calculation is positive, it is an unrealized gain. If the resulting number is negative, it is an unrealized loss.
How to Calculate Unrealized Crypto Gains and Losses
Unlike traditional investments, cryptocurrencies are complicated as there are two methods of buying. The first one is buying crypto with fiat currency, and the second is buying crypto with crypto.
In the traditional investment model, share transactions are straightforward as there is no peer-to-peer trading. Investors generally conduct a stock brokerage and buy different stocks based on future potential. The whole process is relatively simple. You pay cash to the broker and buy stocks, for example, shares of Facebook. Once the stock’s value is higher you have an unrealized gain, and once you sell the stock at a higher value you will make realized gains.
A similar scenario applies to the cryptocurrency market when you buy cryptocurrencies with fiat currencies. For example, let’s say you have bought Ether at $100. You hold the investment until the value reaches the $3,000 level and decide to cash your profit. Once you sell Ether in exchange for fiat currency, you take a realized gain of $3,000 − $100, or $2,900.
But what if you have Bitcoin in your wallet and you’ve bought another cryptocurrency with it?
The exchange of one cryptocurrency to another is also a subject of taxable gain. For example, let’s say you have bought $50,000 worth of Bitcoin and exchanged the BTC for Ether. Later on, the value of the Ether rose and reached $90,000. In that case, the realized gain would be $90,000 − $50,000, or $40,000.
Realized vs. Unrealized in Bitcoin
The realized and unrealized gain in cryptocurrency differs from the traditional financial market, particularly for Bitcoin.
Bitcoin is the most traded cryptocurrency in the world. It has achieved the status of a safe-haven investment opportunity. Moreover, the recent The market capitalization (or market cap) of a cryptocurrency is a measurement of its market value. In other words, it... of Bitcoin has reached $1 trillion, which is a significant milestone for the cryptocurrency market.
The massive retail and institutional involvement in Bitcoin happens through both long-term and short-term capital gains. Moreover, investors buy other cryptocurrencies, altcoins and even invest in DeFi projects with Bitcoin or Ethereum. Therefore, both crypto-to-crypto and crypto-to-fiat transactions occur. So the realized or unrealized gain for Bitcoin is different from traditional assets.
There are usually two models of investment in Bitcoin: Buying a cryptocurrency and holding it for a long time is known as HODL, and speculating on the short-term price volatility is known as active trading.
Let’s look at these two methods in detail.
HODL is often referred to in the cryptocurrency market as “hold on for dear life,” having originated from a misspelling of “hold.” This term is used particularly in a bear market when prices fall, but investors decide not to sell their assets and instead hold onto them with the hope of future price appreciation.
When the price of a cryptocurrency comes down, investors are subject to unrealized loss. However, if HODLers sell cryptocurrencies for a profit, they will earn realized profit.
HODL in Bitcoin involves both realized and unrealized gain/loss. Investors should pay capital gains tax for every realized gain they achieve when they HODL. Any failure to calculate the realized gain accurately will affect your tax calculation.
The cryptocurrency market doesn’t move straight up or down. Rather, it moves with a zig-zag formation.
Therefore, the short-term volatility of price creates a trading opportunity when traders stay active and focused on the price fluctuation.
For example, if you buy Bitcoin at $10,000 with the hope of future price appreciation, it will not reach your target straight off. For example, it might come down first, with some swing lows and highs before moving to your target. Active trading like swing trading is a process to catch those swings, rather than holding the trade as HODLers do.
In active trading, traders take multiple trades from swing levels where every sell is subject to realized gain or loss. Unlike HODL, calculating the realized gain/loss from active trading is complex as the number of trades is greater.
Numerous portfolio trackers and cryptocurrency software programs can help investors manage their realized and unrealized profit/loss. Moreover, these tools often help optimize your tax position. However, you should be aware of the differences between each specific jurisdiction’s capital gains tax rate.
Case Examples of Realized and Unrealized Gains
In this section, we’ll look at some practical examples of realized and unrealized gain in the cryptocurrency market.
Adam is an investor who adopts a long-term buying strategy (or HODL) for Bitcoin. He buys 1 Bitcoin in 2018 for $10,000. In early 2021, Adam finds that Bitcoin has reached $60,000 and he decides to sell it. Here, Adam will gain an unrealized profit of $50,000 as soon as the price reaches the $60,000 level.
Later on, Adam sells his Bitcoin. Due to the price fluctuation, the sale takes place when the price has moved to $58,000. Therefore, Adam makes $48,000 (that is, $58,000 − $10,000) as a realized gain. Now this realized gain is subject to capital gains tax.
When Adam calculates his income tax, he should pay taxes for his realized gain. On the other hand, before selling his Bitcoin there was unrealized gain and, consequently, no income tax charge.
In our second example, Anna is a Bitcoin speculator who catches short-term price fluctuation only. She invests $5,000 in Bitcoin through USDT. On the next day, Anna finds that Ethereum has a higher potential for price appreciation than Bitcoin.
Therefore, she converts the $5,000 worth of Bitcoin to Ethereum. However, the situation worsens when Ethereum’s price crashes, and the value of Anna’s investment drops to $3,000. So Anna exchanges her Ethereum for Bitcoin, with a loss of $2,000.
However, the crypto market became unstable, and Bitcoin’s value started to fall, following Ethereum. Anna’s $3,000 investment in Bitcoin falls to $2,000, and she withdraws this amount in USD.
Here Anna has made two trades:
- First, she bought Ether using the BTC and took a loss of $2,000
- Next, she exchanged Bitcoin with USD and took a loss of $1,000
In the first trade, Anna made a crypto-crypto exchange, so her $2,000 is a realized loss that will affect her income tax calculation. In addition, in the second trade, Bitcoin was exchanged for fiat currencies, making it possible for Anna to consider the $1,000 hit as a realized loss.
Any exchange of cryptocurrency or fiat currencies involves realized or unrealized gain/loss. The ultimate effect of these gains/losses is a respective increase or decrease in taxable income.
It is often difficult for traders to find the right time to sell a crypto asset. Selling a crypto asset for profit will provide realized gains, but investors will pay taxes on this gain. On the other hand, selling a crypto asset with loss may incur realized loss, allowing investors to take a deduction on their taxable income.
In this context, the best approach is to minimize the capital gains tax as much as possible by holding a crypto asset for a considerable time.
Moreover, timing the market is very important as the financial market is very volatile. Investing involves risks. Investors can reduce loss by diversifying their portfolios with multiple crypto assets so that one gains in one investment may offset losses from others.
Additionally, following a strong trading strategy is important. Investment in the financial market is not a guessing game. There should be logic and reason behind every decision.
Overall, besides endeavoring to remain continuously profitable, investors should keep realized profit/loss in their tax planning.