When dividing assets during a divorce, many people focus on the balances shown on account statements. If two assets are each worth $500,000, it's easy to assume they have the same overall value.
However, not all assets with the same market value are truly equal. Some assets carry future tax consequences that others do not, meaning two accounts with identical balances may ultimately have different after-tax values.
One reason for this is embedded capital gains, or the unrealized appreciation within an asset. Understanding this concept can help divorcing spouses better evaluate the after-tax value of different assets and make more informed financial decisions during settlement negotiations.
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What Is Cost Basis?
To understand embedded capital gains, it helps to first understand cost basis.
Cost basis is what you originally paid for an asset, subject to certain adjustments over time.
For example, if you purchased an investment for $100,000 ten years ago and today it is worth $150,000, your cost basis is generally $100,000.
What Are Embedded Capital Gains?
Once you understand cost basis, it’s easier to understand embedded capital gains.
Using the previous example, the $50,000 increase in value between the investment's current market value ($150,000) and its cost basis ($100,000) is its embedded capital gain.
Why Embedded Capital Gains Matter in a Divorce
When evaluating settlement options in a divorce, it's important to look beyond an asset's current market value. Consider the following two investment accounts:
Account A
- Current Value: $500,000
- Cost Basis: $480,000
- Embedded Capital Gain: $20,000
Account B
- Current Value: $500,000
- Cost Basis: $100,000
- Embedded Capital Gain: $400,000
At first glance, both accounts appear equal because each is worth $500,000.
However, because Account B has a much lower cost basis, it has a substantially larger embedded capital gain.
In many cases, transferring an appreciated asset as part of a divorce settlement does not immediately trigger capital gains taxes. Instead, the spouse who receives the asset may be responsible for taxes on its appreciation if they later sell it.
As a result, although both accounts were worth the same amount at the time of the divorce, they may not ultimately provide the same after-tax value if the investments are eventually sold.
📌 Learn more - What Are Capital Gains (and When Do You Pay Taxes on Them)
Embedded Capital Gains and the Family Home
Embedded capital gains aren’t limited to investment accounts.
The family home can also contain significant appreciation.
For example, a home purchased years ago for $300,000 may now be worth $900,000. That increase in value can create important financial considerations when negotiating a divorce settlement.
If the home is ultimately sold, some of that appreciation may be subject to capital gains taxes. However, the tax treatment of a primary residence is subject to special rules, and any potential tax consequences depend on factors such as the home's cost basis, eligibility for certain tax exclusions, and the homeowner's individual circumstances.
📌 Learn more - Should You Keep or Sell the House After a Divorce?
Looking Beyond Account Balances in a Divorce
When dividing assets during a divorce, current market value is only part of the picture. Two assets with identical balances today may ultimately have very different after-tax values if they are later sold. Understanding embedded capital gains can help divorcing spouses look beyond account balances and better evaluate the assets they may receive as part of a settlement.
If you would like to discuss how embedded capital gains, cost basis, and other financial considerations may affect your divorce settlement, we're here to help. You can schedule a complimentary introductory meeting with our team in Glastonbury or Wilton, Connecticut, to discuss how different settlement options may fit into your broader financial plan.
Have a quick question instead? Send us a note.
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Kelsey Conklin is a CERTIFIED FINANCIAL PLANNER® professional and Certified Divorce Financial Analyst® professional who helps individuals and families plan for their financial future. Based in Glastonbury and Wilton, CT, she also specializes in financial planning for women, guiding her clients through divorce, widowhood, career transitions, caregiving responsibilities, retirement planning, investing, and managing longevity risks. As a female financial advisor, Kelsey is passionate about financial empowerment for women and provides personalized financial strategies designed to help women take control of their wealth with clarity. Whether you’re navigating major life changes or planning for retirement, she is committed to providing guidance tailored to your goals. Schedule a complimentary Women and Wealth introductory meeting with Kelsey and start building a financial plan designed for you.
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