Income has a very broad definition, including increases in wealth from any source. The concept of realized income is important for tax purposes because it separates income that isn't subject to current taxation from income that potentially could be subject to tax. Let's take a closer look at what realized income is, and how to calculate it.
What realized income isRealized income includes income that you've actually earned and received. Wages and salary income that you earn is included in realized income, as are interest and dividend payments from your investment portfolio. For those who invest in real estate, rental income is also realized when received, and small businesses owners can include their business income, as well.
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Where there's an important distinction between economic income and realized income is with appreciating assets. If a stock you own rises in value, then you have an economic gain, which is sometimes called a paper gain. However, that doesn't become realized income until you actually sell the stock. Because of this distinction, long-term investing is a powerful way to defer taxation, as you control when you sell, and therefore, when your gains will be subject to tax.
Calculating realized income is as simple as adding all these sources of income together. However, once you do, there's another step you'll need to consider if you want to figure out the income on which you'll be taxed.
Realized income vs. recognized incomeIn trying to determine taxable income, realized income is only an intermediate step. The tax laws allow taxpayers to avoid recognizing certain types of income for tax purposes, even once it's realized.
One example is with the sale of a home. Any profit from that sale is realized income. However, current tax law provides single taxpayers with an exemption of up to $250,000 from capital gains taxes on the sale of a qualifying personal residence. As a result, the IRS doesn't treat capital gains up to that amount as recognized income, and therefore, you're not taxed on it.
Knowing your realized income is important, but it's not always the final answer you want. Only by considering tax exemptions on certain types of realized income will you get the result that you're really looking to find.
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