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Sometimes referred to as a paper loss, an unrealized loss is a situation in which an investor has sustained a loss on a stock or other security, but has not yet officially taken the loss. This unrealized loss may be a temporary situation, assuming that the value of the security begins to increase once more, and exceeds the price that was originally paid for the shares. Should the investor choose to sell the security while the price is still below that original purchase price, the unrealized loss is realized and can be claimed as a capital loss.
The easiest way to understand the nature of an unrealized loss is to consider the purchase of a thousand shares of a given stock. Several weeks after that purchase, the value of those shares begin to plummet, owing to some unanticipated event or shift in the marketplace. Within a day or two, the value of those shares is half of what the investor paid initially. This means that the shareholder has experienced a fifty percent unrealized loss on the investment.
Depending on the circumstances surrounding the trend, the investor may project that the stock will soon level off and begin to increase in value once more. If that is the case, he or she may choose to hold onto the shares and eventually reduce the amount of unrealized loss as the stock value increases to a level that is more than the original purchase price. This would create what is known as an unrealized gain.
Should the stock fail to recover and instead continue the downward trend, the investor will experience an increase in unrealized loss. Once it is clear that the stock is not going to recover, the investor would do well to sell the shares before the value decreases any further, and thus prevent any further increase in the loss. Upon the sale of the stock, the unrealized loss becomes a realized loss, and can be claimed as tax deduction during the period when the loss is realized.
Both an unrealized loss and an unrealized gain remain in that state until the investor chooses to sell the security. At that point, the gain or the loss is realized, and the value of the investment portfolio is adjusted accordingly. This is important, since many tax agencies do not consider capital gains to be taxable until those gains are realized. In addition, the loss usually cannot be claimed as a deduction until the amount is realized.