Short answer: A gain is unrealised while you still own the asset and it has simply gone up in value. It becomes realised when you sell, exchange or otherwise dispose of it. US income tax generally waits for realisation: an unrealised gain is not taxed, and an unrealised loss cannot be deducted. Funds report both in their financial statements and NAV, but the K-1 follows only what has been realised for tax. The gap explains a lot of fund tax, from book-tax differences to phantom income. There are important exceptions, where the tax code treats a gain as realised without a sale.
The difference in one example
A fund buys shares for $10 million. At the end of year 1 they are worth $14 million. In year 2 it sells them for $13 million.
| Year 1 | Year 2 | |
|---|---|---|
| Financial statements (fair value) | $4 million unrealised gain | $3 million realised gain, less the $4 million unrealised gain reversed: net $1 million loss |
| NAV and TVPI | Up by $4 million | Down by $1 million |
| Taxable gain on the K-1 | None | $3 million |
Over the two years both views show $3 million of profit. They simply put it in different years. The investor's IRR and multiples rise in year 1, while their tax bill arrives only in year 2.
Why tax waits for realisation
The tax code taxes gain from the sale or other disposition of property: the amount realized less adjusted basis. Until there is a disposition, there is no amount realized, so there is nothing to measure. Taxing paper gains would also force owners to sell assets to pay tax on value they may never receive.
Where the gap shows up in funds
- Financial statements. Investment funds generally carry investments at fair value, so unrealised gains and losses run through their reported income. For tax they don't. The difference is a classic book-tax adjustment, reported on Schedule M-1 or M-3.
- Capital accounts. When a fund revalues its assets, for example when a new investor joins or a promote is granted, partners' book capital accounts change to reflect unrealised gains. That is a book entry, not a taxable event.
- Carried interest. Accrued carry on unrealised gains sits in the manager's book capital account. The manager is taxed only when the fund realises gains and allocates them.
- Distributions in kind. A partnership that distributes property instead of selling it generally recognises no gain, and the partner recognises gain only to the extent cash exceeds its basis in the partnership. For this purpose marketable securities count as cash, so an in-kind distribution of listed shares can trigger gain for the partner.
- Unrealised losses cannot be deducted, however large. A fund that wants the loss must sell.
When tax treats a gain as realised without a sale
The realisation rule has exceptions that matter for funds:
- Mark-to-market regimes. Dealers in securities, and traders who elect, under section 475; regulated futures and other section 1256 contracts, which are treated as sold at year-end (60% long-term, 40% short-term); and the PFIC mark-to-market election. In each case, year-end value is taxed as if sold.
- Constructive sales. Locking in an appreciated position, through a short sale against the box, an offsetting swap or a forward contract to deliver the same property, is a constructive sale under section 1259, and the gain is recognised as if the position were sold at fair market value that day.
- Income without cash. Some income is taxed as it accrues even though nothing is paid, such as original issue discount and PIK interest on loans held by credit funds. That is phantom income, a cousin of this topic rather than unrealised gain.
- Deemed transactions. Some elections and events are treated as sales or liquidations, for example a check-the-box change that turns a corporation into a disregarded entity, which is treated as a liquidation.
What this means for investors
- NAV is not taxable income. A strong year on paper can come with a small K-1, and a weak year on paper can come with a large one when old gains are finally realised.
- Tax timing is partly in the fund's control. Choosing when to sell, whether to distribute in kind and whether to make elections changes when gains are realised.
- Plan cash for tax. Realised gains are allocated whether or not they are distributed, so investors and managers rely on tax distributions to cover the tax.
This explainer is general information, not tax advice.
Sources
- 26 U.S. Code § 1001, Cornell LII
- 26 U.S. Code § 731, Cornell LII
- 26 U.S. Code § 1256, Cornell LII
- 26 U.S. Code § 1259, Cornell LII
- 26 U.S. Code § 475, Cornell LII
Related reading
- Schedule M-1 and M-3: Book-to-Tax Adjustments Explained
- IRR and Fund Cash Flows, Explained
- Glossary: Phantom income
This explainer is analysis and general information, not tax, legal or investment advice.