What exactly is "realized income"?

[somebody8198]

I have been reading "The Millionaire Next Door" and the author likes to point out that wealth people have large net worth but relatively low "realized income." I kind of have an idea of what this mean – it's the amount that is reported as income on your tax forms. But that seems a bit like a tautology. What is the technical definition of "realized income"? If I make $2000 due to an appreciating asset like a stock, does it really count as "income"? I'm just a bit confused by the terminology.

[seattlecyclone]

A "realized" capital gain is one that you need to report on your tax return because you sold the shares. An "unrealized" gain is the difference between the current value of an asset and the amount you paid for it. It doesn't become a realized gain until you sell the asset.

[SwordGuy]

You own a car that you paid $10,000 for.

I say, "Cool car! I'll give you $15,000 for it."

You decide not to sell the car.

Did you just make $5000?

Should you have to pay tax on that $5000?

The answers are "No and Hell no!"

You're probably thinking, "Duh.  That's obvious!"

If you sold the car, you would have realized the $5000 gain and you would owe taxes on that $5000.

Ditto for stocks.

Also, you owe when you receive a dividend on the stock, as that's "real" money.

[somebody8198]

I understand the difference between an unrealized gain and a realized gain. What I don't quite get is how that unrealized gain can be considered "income." When I talk about income I usually mean gross pay, cash, liquid assets coming in. In other words, money that could be spent or invested or used to pay off a loan. Would you count unrealized gains from the stock market as income, even if you don't have to report it on your tax forms?

[MDM]

I understand the difference between an unrealized gain and a realized gain. What I don't quite get is how that unrealized gain can be considered "income." When I talk about income I usually mean gross pay, cash, liquid assets coming in. In other words, money that could be spent or invested or used to pay off a loan. Would you count unrealized gains from the stock market as income, even if you don't have to report it on your tax forms?

Does it help to consider "gain" and "income" as two words for the same thing?

There is a simple equation that applies to many things: In - Out = Accumulation.

E.g., your net worth goes up if you have more income than outgo and vice versa.  That income can be, among other things, gross pay or stock price increase.

[Paul der Krake]

To complicate things a little, what's realized and unrealized doesn't always follow intuition. The classic example right now in the tech world is exercising options in a private company at a strike price that is under fair market value, which triggers tax on the difference even though the exerciser has no market to redeem his shares for cash.

A quick web search will reveal many horror stories of unsuspecting taxpayers caught in this "funny" interpretation of realized income.

[Drifterrider]

If you sold the car, you would have realized the $5000 gain and you would owe taxes on that $5000.

Nope.  Gains of the sale of a personal vehicle are exempt from taxes.  Gains on the sale of most personal property are exempt also.  Property used to generate ordinary income (used car salesman) are not personal property.

[El Marinero]

If you sold the car, you would have realized the $5000 gain and you would owe taxes on that $5000.

Nope.  Gains of the sale of a personal vehicle are exempt from taxes.  Gains on the sale of most personal property are exempt also.  Property used to generate ordinary income (used car salesman) are not personal property.

Not so fast.

Gains on sale of personal property such as an auto definitely ARE taxable income in the US.  However, losses on sale of personal property are not deductions.

The fact that no 1099 is issued and most folks don't report or keep track of personal property gains doesn't mean you aren't legally required to report them as income.

[skuzuker28]

Things get even more confusing when you have to differentiate between "recognized" and "realized" income.  Examples would be 1031 exchanges and Roth retirement accounts. 

1031 you can have a very large realized gain, but not recognize any of it for income tax purposes because that gain is rolled in to the basis of the new asset.

For Roth accounts you have realized income from the gains on the investments in the account, but do not recognize any of it after 59.5 due to the tax-favored status of the account.

[jwright]

I understand the difference between an unrealized gain and a realized gain. What I don't quite get is how that unrealized gain can be considered "income." When I talk about income I usually mean gross pay, cash, liquid assets coming in. In other words, money that could be spent or invested or used to pay off a loan. Would you count unrealized gains from the stock market as income, even if you don't have to report it on your tax forms?

In the stock example, an unrealized gain is not income, but it does increase your net worth; similar to appreciation of real estate. 

If I invest in stocks for long term growth, they may not pay me dividends every year (so low income), but my net worth increases because the value of the portfolio increases. 

Basically the folks with high net worth and low income are just sitting on their assets/money and not doing anything with it that would trigger income recognition.