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Understanding the distinction between actual and unrealised gains and losses is one of the most critical facets in investing in or selling cryptocurrencies (PnL). First, because they affect how much you potentially win or lose from cryptocurrency trades, but also because of future tax responsibilities.
Where Does the Concept of Realized vs. Unrealized PnL Come From?
The concept of realized and unrealized PnL in cryptocurrencies is based on the same principles used for stocks, shares, or commodities. To explain it, let’s first consider trading or investing in company stocks.
what is an unrealized p&l?
Assume you purchased ten Tesla shares for $500 each, for a cumulative investment of $5,000. The stock price then rises by $50. Your money is now valued at $5,500. As long as you retain the shares, the benefit is said to be “unrealised,” because it remains only on paper.
Similarly, if the share price falls by $50, the Tesla stake will now be worth $4,500, representing an unrealised loss as long as you continue to own the shares.
what is a realized p&l?
Once you sell the shares, any profit or loss you make on the investment becomes a realized profit or loss.
Perhaps notably, unrealised profits and losses do not generally result in a taxable case. Depending in the state, when you sell properties at a fee, you might be entitled to capital gains tax. When you sell at a loss, you will be able to subtract the capital loss from your tax liability.
So, let’s presume you sell your Tesla stock when it’s still profitable. If capital gains tax were applied, it will be levied only on your $500 benefit. If you sell when the price was low, you could claim a tax refund on the $500 loss, which you could cover against other profits.
Realized vs. Unrealized PnL in Bitcoin
Cryptocurrencies are a little more complicated than shares due to the variable ways they’re treated for tax purposes in different jurisdictions.
Furthermore, since shares are not tradeable among themselves, share exchanges are relatively simple. Using the previous example, if you were to exchange your Tesla stock for Apple stock, you’d have to sell your Tesla stock for cash and then use the proceeds to purchase Apple stock.
For cryptocurrencies, you could use fiat currencies to purchase BTC and then exchange it for other cryptocurrencies without ever having to translate back to currency.
As a result, transactions between cryptocurrencies are often treated as a realised benefit or loss and taxed accordingly.
Let’s work through a few examples to illustrate how this works in practice.
Long-term Buy and HODL
Alice is a long-term trader who prefers to buy and hold. During the 2018 crypto winter, she purchased one BTC for $5,000 in fiat. She had an unrealised benefit of $53,000 in early 2021, as the price of BTC increased to $58,000. She made the decision to sell. She wasn’t quite fast enough to catch the top, but she was able to sell her one BTC for $55,000, resulting in a $50,000 profit.
In this straightforward case, assuming Alice is subject to capital gains tax, it would be calculated based on $50,000 (her realized profit).
Bob is a dealer who bets on the volatility in cryptocurrencies in the short term. Bob spends $5,000 on one Bitcoin. The next day, BTC’s value towards ETH rises, so Bob decides to profit. He exchanges his one BTC for $8,000 in ETH. However, it was a wrong idea because ETH rates are still down. The next day, Bob agrees to cut his losses and sells his ETH spot for $7,000 in USDT.
About the fact that he has not transferred any funds back to fiat, Bob’s transactions in this series are called realised profits and losses.
Bob realised a $3,000 benefit in the first trade by selling his BTC. Remember that he paid $5,000 for BTC and sold it for $8,000 in ETH. The $3,000 is subject to capital gains tax since it is a realised bonus.
In the following trade, Bob discovered a $1,000 loss by selling his $8000 worth of ETH for $7000 worth of USDT. He will use the capital loss tax allowance to cover his capital benefit tax liability.
Keeping Track of Realized and Unrealized Profits and Losses
Bob’s example is still pretty simple. It can get very difficult if traders have several positions that they purchased at varying rates. What if Bob already had BTC purchased at various rates at the time of his first trade? The cost base is used to quantify the trade’s profit?
Keeping track of any of these transaction information manually can be difficult, particularly for traders. Failure to correctly record cryptocurrency profits and losses would be highly dangerous, as tax officials can regard it as fraud. As a result, many cryptocurrency users opt for various tools and services to assist them in remaining compliant.
Portfolio trackers and cryptocurrency tax software are two of the most popular applications to help manage your realized and unrealized PnL. Delta, CryptoCompare, and Blockfolio are all examples of all-in-one solutions for crypto traders. However, there are plenty of others on the crypto market.
In many cases, these tools can also assist you in optimising your tax position by tracking your unrealised PnL. Tax-loss harvesting is a technique that allows you to sell certain positions at a realised loss in order to reduce your capital gains liability.
You should be mindful that certain crypto tax platforms only protect certain jurisdictions, so make sure the one you select will meet your tax obligations.
Finally, it is critical to understand that tax laws and regulations for cryptocurrencies will differ substantially between jurisdictions. The material in this article is intended to provide you with a general understanding and should not be construed as tax advice. Before selling cryptocurrency, make sure you grasp the tax laws that relate to your specific situation.