A realized loss is a loss that is only recognized when assets that have decreased in value have been sold and the selling price was lower than the original purchase price. Until the assets are actually sold, the loss exists only on paper and is referred to as a paper loss. It is not usually possible to report a paper loss on tax returns and receive some sort of tax break. Only when the loss becomes realized can it be used to offset the amount of taxes owed for the period.
One way to understand how a realized loss functions is to consider the example of the purchase of a round lot of shares. If that round lot included one hundred shares of stock valued at $10 US Dollars (USD), the investor's initial investment comes to $1,000 USD. Should the stock fail to maintain its value, and falls to a price of $8 USD per share, the investors sustains a paper loss of $200 USD.
In order to post a realized loss, the investor would need to sell that round lot of one hundred shares at the current market price of $8 USD per share. This would allow the investor to recoup 80% of the initial investment, while sustaining a realized loss of $200 USD. That $200 USD capital loss can then be claimed as a loss on the tax return covering the period where the shares were actually sold. Assuming the investor has other assets that posted capital gains during the same period, this loss can be used to help reduce the taxes owed on those gains.
It is important to note that a realized loss only takes place when the assets that have sustained the loss are sold. This means it is possible to sustain the paper loss in one accounting period, but not realize the loss until the assets are sold at a loss in a subsequent accounting period. For example, if the price on a given security falls in one tax year, but that security is not actually sold at a loss until the following tax year, the realized loss can only be claimed in that second year, and not for the year where the decrease in market value occurred.
Investors sometimes delay the sale of worthless securities until that sale would significantly aid in offsetting the capital gains earned on other investments. This means that the investor may allow the paper loss to ride for several accounting periods before taking steps to sell the stocks for whatever is considered the current market value. Doing so helps to not only reduce the impact of the loss on the overall investment portfolio, but also helps to reduce the tax burden for the period where the actual or realized loss is sustained and allow the investor to retain more of the profits earned from those investments that were sold at a realized gain.
