What is unrealized gain? Profit from it like Elon Musk

What is unrealized gain? Profit from it like Elon Musk

Last week, Tesla CEO Elon Musk asked his Twitter followers if he should sell 10% of his Tesla shares. The Twitter poll responded with a 57% Yes. Following the poll, Musk sold Tesla shares, sending the stock down.

In his tweet, Musk first mentioned how much is made of billionaires like him using unrealized gains to avoid taxes. Then, he mentioned that he does not take a salary or bonus from the company. So, the only way he pays taxes is when he sells the stock. In this article, we will discuss what an unrealized gain is and how you can take advantage of it just like a billionaire. Read Musk’s full tweet below.

What is an unrealized gain?

An unrealized gain is simply the capital gain of a stock that has not been sold, yet.

If you bought Tesla shares earlier in 2020 for $95 and held it in your account when the price of the stock appreciated to $1,000, your unrealized gain is $905. In simple terms, it is the difference between your original purchase price, also known as the cost basis, and the current price of the stock.

Realized vs. unrealized gain

While unrealized gain is only a paper gain, it becomes a realized gain when you sell the investment. This is significant because you only pay taxes on realized gains

Now, let’s assume that the Tesla shares you bought for $95 appreciates to $1,000 and you sell it at that price. At this point, you realize the $905 gain and will pay capital gains tax on this amount. Read our blog on how to avoid capital gains tax here.

Can you have an unrealized loss?

Yes, if the price of a stock goes down after you buy it, it would be a capital loss. Instead of an unrealized gain, it would be called an unrealized loss. Unrealized losses can be advantageous for tax reasons because once the loss becomes realized, unrealized gains and losses can offset each other, thus reducing your tax bill.

How do billionaires avoid paying taxes using unrealized gains?

1. They are owners instead of workers

In the second part of his tweet, Musk says that he does not take any salary or bonus. So, the only way for him to pay taxes is capital gains when he sells stocks.

Earnings from salary or bonus are treated as income and those from stock gains as capital gains. The tax system has traditionally favored owners over workers, likely to encourage more entrepreneurship and risk-taking. Hence, capital gains tax rates are generally lower than income tax rates.

Musk figures that his Tesla stocks going up in value is compensation enough for him. So, he chooses not to take a salary but to get paid with the growth of his stocks instead.

  • How you can do this

Remember that when you buy a stock, you are an owner of a portion of the company. When your stocks appreciate in value, you also create wealth for yourself in the form of unrealized gain that you can choose to sell and realize, just like Musk.

This is different from investing in real estate or any investment that produces an income, where you are required to pay tax on the rental income as soon as you receive it. You can build wealth by buying stocks and remember, the earlier you invest, the more it can appreciate over time.

2. They get help from financial planners and tax planners

Having unrealized gain allows you to choose when you pay taxes. In other words, you can decide when you want to sell the stock and realize the gains. This allows you to manage your taxes well in advance and coordinate life events such as retirement or activities such as charitable giving with ways to also reduce taxes.

  • How you can do this

While billionaires like Musk likely have staff on-site to handle their financial and tax affairs, you can also get professional help. A financial planner can proactively guide you to take advantage of tax planning opportunities available to you at different stages of your life.

3. They plan for estate taxes

One of the biggest benefits of accumulating wealth as unrealized gains is that you can completely avoid ever paying capital gains tax and pass it tax-free to your heirs. One of the most popular ways in which you can do this is through a step-up in basis.

When a person dies, the inheritance goes through a step-up in basis where the cost basis resets to the market value on the day of the death. When that happens, the unrealized gain can literally go from billions to $0. This means that when you sell the stock, you will not pay any capital gains tax.

  • How you can do this

The step-up in basis is one way to avoid capital gains tax. If you have substantial assets today or if there’s a strong possibility of it growing significantly over your lifetime, estate planning can help you minimize the impact and maximize the wealth you pass to your heirs or to a charity.

4. They pay attention to after-tax returns

Your personal finance goal should always be to maximize your after-tax returns.

If an investor waits for more than 12 months before selling an asset, the gain on the sale is a long-term capital gain. On the other hand, if the investor holds the asset for less than 12 months, the gain is a short-term capital gain. Short-term capital gains are taxed as regular income. Long-term capital gains enjoy a lower rate.

  • What you can do

Besides becoming a long-term investor, pay attention to your asset location. Keep assets that can appreciate significantly in a Roth account. That way, you can completely avoid paying any capital gains on those assets.

Take action today

While the billionaires certainly have lots of resources, many of their tax planning tools are also available to the rest of us. The tax codes are always changing, but planning for these changes in advance can lead to better outcomes, than going without a plan. If you would like to understand how working with a financial planner can help you, please book some time below:

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