Realized vs. unrealized capital gains

To read more chapters, click below:

Chapter 1: All that you want to know about Capital Gains in Canada

Chapter 2: Effect of capital gains on property and investments

Chapter 4: Capital Gains on Primary Residence and Principal Residence Exemption

In the previous two chapters the details of capital gains were discussed. By now you must be aware that capital gains refer to the profit earned from the sale of an asset, such as stocks, real estate, or investments, at a price higher than its original purchase price. It represents the difference between the selling price and the cost basis (purchase price) of the asset. Capital gains can be subject to taxation depending on various factors, including the holding period and tax laws in a particular jurisdiction.

In this chapter we’ll discuss the difference between realized and unrealized capital gains. Here are some points that you should keep in mind –

• Realized capital gains represent the actual profits you've obtained from selling an asset, and they become liable to capital gains tax.
• Conversely, unrealized capital gains are an approximation of your potential profits. Because you haven't completed a sale, you are not obligated to pay taxes on them.
• Monitoring your unrealized capital gains can aid in evaluating your financial status and determining the opportune moment for selling your assets.

What are realized capital gains?

Realized capital gains are concrete; when you've sold your asset and made a profit, it becomes a reality. The same principle applies to realized capital losses: when you no longer hold the asset and have incurred a financial loss in the transaction.

Consider the stock you purchased. You initially bought it for $1,000, and now it's valued at $2,000. It's an opportune moment to sell! Once the sale is executed, the profit ceases to be an estimate; it transforms into an indisputable fact. The $1,000 profit is then categorized as a realized capital gain.

In Canada, realized capital gains are profits earned from the sale or disposition of certain assets, and they are subject to taxation. The tax treatment of realized capital gains in Canada is as follows –

• Taxable Capital Gains: When you sell or dispose of an asset, such as stocks, real estate, or investments, and the selling price exceeds the original cost of the asset (known as the adjusted cost base), the difference is considered a taxable capital gain. In Canada, only 50% of the capital gain is included in your taxable income.
• Principal Residence Exemption: The sale of a principal residence is usually exempt from capital gains tax in Canada. However, this exemption may not apply if the property was used for income-generating purposes (e.g., renting out a portion of the home) during your ownership.
• Small Business Deduction: If you sell shares of a qualified small business corporation, you may be eligible for a lifetime capital gains exemption, which allows a portion of the capital gain to be tax-free, up to a specified limit.
• Tax-Deferred Accounts: Capital gains earned within tax-deferred accounts like Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) are not subject to immediate taxation. However, withdrawals from RRSPs are treated as taxable income, while TFSA withdrawals remain tax-free.
• Offsetting Capital Losses: You can offset realized capital gains by applying capital losses from other investments in the same tax year or carrying forward unused losses from previous years. This can help reduce your overall capital gains tax liability.
• Special Rules for Gifts and Inheritance: There are specific tax rules for capital gains when assets are received as gifts or inheritances. In most cases, the recipient does not pay tax on the capital gain when they acquire the asset, but there may be tax consequences when they eventually sell it.

What are unrealized capital gains?

In Canada, unrealized capital gains refer to the increase in the value of certain assets that you hold but have not yet sold or disposed of in a transaction. These gains have not been "realized" because they are only on paper and have not resulted in actual cash proceeds. Here's what you need to know about unrealized capital gains in Canada –

• Taxation: Unrealized capital gains are generally not subject to immediate taxation in Canada. You are only required to report and pay taxes on capital gains when you sell or dispose of the asset, thereby "realizing" the gain.
• Valuation: To determine the value of unrealized capital gains, you calculate the current market value of the asset minus its adjusted cost base (ACB). The ACB is essentially the original cost of the asset plus any allowable expenses incurred during ownership.
• Principal Residence: The increase in the value of your principal residence is typically considered an unrealized capital gain, and it is usually exempt from capital gains tax when you sell the property. However, certain conditions and criteria must be met for the principal residence exemption to apply.
• Investment Assets: For other types of investments, such as stocks, real estate (other than the principal residence), and investment properties, you are not required to pay capital gains tax until you sell the asset and realize the gain. At that point, the capital gain becomes a realized capital gain and is subject to taxation.
• Carryforward of Losses: If you have unrealized capital losses from previous years, you can carry them forward to offset realized capital gains in future years, reducing your overall tax liability.
• Tax-Deferred Accounts: Investments held within tax-deferred accounts like Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) generate unrealized capital gains that are not subject to immediate taxation. However, tax implications may arise upon withdrawal or sale of assets within these accounts.

It's important to remember that tax rules and regulations regarding unrealized capital gains can be complex and subject to change. Consult with a tax professional or accountant for personalized guidance and to ensure compliance with current tax laws in Canada.

Difference between realized and unrealized capital gains

Realized and unrealized capital gains are two key concepts in the world of investments and taxation, and they differ in terms of timing and taxation.

Realized Capital Gains

• Timing: Realized capital gains occur when an asset is sold or disposed of in a transaction, resulting in an actual profit.
• Taxation: They are subject to taxation in many jurisdictions, including capital gains tax. The tax liability is realized and paid in the year of the sale.
• Example: If you purchase a stock for $1,000 and later sell it for $2,000, the $1,000 profit you make at the time of the sale is a realized capital gain.

Unrealized Capital Gains

• Timing: Unrealized capital gains represent the increase in the value of an asset that you currently hold but have not sold or realized in a transaction. They are paper gains.
• Taxation: They are typically not subject to immediate taxation. You only pay taxes on these gains when you sell the asset and realize the profit.
• Example: If you own a piece of real estate that has increased in value from $200,000 to $250,000 but have not sold it, the $50,000 increase in value is an unrealized capital gain.

In summary, the main difference between realized and unrealized capital gains lies in whether the profit has been "realized" through a sale or transaction. Realized gains are actual profits that have been cashed in, while unrealized gains represent potential profits that have not yet been realized because the asset has not been sold. Taxation generally applies to realized capital gains, whereas unrealized gains are often not subject to immediate taxation until the asset is sold. It's important to be aware of the tax implications associated with both types of gains, as they can vary depending on your jurisdiction and individual circumstances.

Are you required to settle taxes on unrealized capital gains?

In Canada, there's no obligation to pay taxes on unrealized capital gains. These gains remain theoretical: although you may include them in your net worth calculations, no actual transaction has occurred, and you continue to possess the asset.

On the contrary, realized capital gains are indeed subject to taxation, given the occurrence of a transaction.

How can we handle unrealized gains?

If you have a portfolio of stocks, it's likely you receive periodic statements reflecting their current value. Alternatively, you can access your account online to check their worth. This serves as a valuable tool for monitoring your investments and overall net worth, empowering you to make informed financial decisions. However, it's important to note that these gains are primarily relevant for planning purposes. There is no requirement to pay taxes on unrealized gains.

The same principle applies to properties, including houses and other real estate. You can estimate their potential selling value, which can be useful for actions like remortgaging and securing lines of credit. However, until an actual sale occurs, these capital gains remain in the realm of the unrealized.

Are capital gains that are reinvested subject to taxation?

Once your capital gains are realized, typically through a transaction like a sale, they become taxable. Generally, you must report them in the same tax year as the calendar year in which the transaction occurred. For example, if you sell a property at a profit in 2023, that profit qualifies as a taxable capital gain and should be included in your 2023 income tax return.

The intended use of the capital gains (i.e., how you plan to reinvest or utilize the money) does not affect the tax liability. When you sell an asset and generate a profit, you are obligated to pay tax on that amount.

However, there are exceptions, such as investments held within registered accounts like a Tax-Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP). Capital gains within a TFSA remain tax-free, and profits within an RRSP are shielded from taxation until you withdraw the funds, typically at retirement age. This feature makes TFSAs and RRSPs valuable tools for saving money, as they provide tax shelters that protect your capital gains from being taxed.

Is it possible to circumvent the unrealized capital gains tax?

In Canada, unrealized capital gains remain non-taxable as long as they remain unrealized, meaning you are not required to pay taxes on them.

If you are contemplating selling an asset, thereby converting unrealized capital gains into realized (and taxable) capital gains, thoughtful planning can be employed to reduce the tax burden. For instance, you might opt to sell the asset in a year when your income, and consequently, your tax bracket, is lower.

Alternatively, when selling stocks, you could consider splitting the sale between two tax years by selling half in one year and the other half in another. While the values may not be precisely the same due to market fluctuations, a strategic split, such as selling one half on December 31 and the other half on January 1, can help mitigate the tax impact.