Research suggests that emotions influence children's ability to discern fantasy from reality; however, reasons for this association remain unknown. The current research sought to better understand the mechanisms underlying children's distinctions by examining the roles discrete emotions and context have in 3- to 5-year-olds' evaluations of fantasy and reality. In Study 1, children's fantasy-reality distinctions of images depicting happy, frightening, or sad events were obtained under two conditions: Children responded freely or were motivated to respond accurately. When responding freely, older children reported that happy and sad fantastic and real events could occur but frightening events could not. When motivated to respond accurately, children's accuracy improved for fantasy but not for reality. Study 2 examined real events exclusively and found that children may lack the knowledge that frightening, but not happy or sad, real events can occur. The findings provide new insight into how emotions affect children's fantasy-reality distinctions. (Contains 2 tables.)