Transferring Assets in a Divorce Can Lead to Capital Gains Tax Implications

The process of distributing assets and debts in divorce is a process couples focus on in great detail.  It can often be very contentious, which is not surprising since marital property not only holds financial value but emotional value as well.

In their quest to gain particular assets and secure fair value, couples often fail to consider issues that can impact the true value of assets in the long run.  Although transfers of assets between spouses incident to divorce are generally tax-free, meaning that assets can be transferred between spouses without triggering capital gains taxes at the time of the divorce, all assets are not created equal, and capital gains tax liability arising from a subsequent sale or exchange of assets received in a divorce is one major reason for that.

Understanding Capital Gains Tax

Capital gains tax differs from income tax in that it is a tax levied on the profit realized from the sale or exchange of certain assets, known as capital assets.  Capital gains tax is triggered when an asset is sold or exchanged for a higher price than its original purchase price. The tax is calculated based on the difference between the sale price and the adjusted basis of the asset. The amount of profit is your capital gain, and that profit is taxed. 

If the investment was not held long, the gain is usually taxed at a higher rate than the rate that applies to long-term investments. But at any rate, capital gains can pose a significant obligation.

To calculate capital gain, you generally subtract the original price paid for the asset, which is the basis, from the sale price. For instance, if you bought 1000 shares of stock valued at $50 a share and later sold it for $90 a share, you would have a capital gain of $40 per share or $40,000. If the gain is taxed at a rate of 15%, then the person responsible for paying the tax would owe $6,000. In some instances, the “basis” can be increased by monies spent to improve the asset such as capital improvements to real property.

Consider Potential Tax Obligations as Part of the Property Settlement

Because of capital gains tax liability, two assets with an equal face value may have an actual worth that differs substantially. If one spouse keeps recently acquired stock worth $50,000 while the other takes shares that have appreciated in value to a current price of $50,000, that spouse is actually receiving less value when you factor in the capital gains tax obligations. Transferring the stock to one spouse in divorce will not trigger a tax bill, but at some future point in time (usually when the asset is sold), the tax on the gain will need to be paid or offset, and that puts the spouse taking the appreciated asset at a substantial disadvantage.

When dividing assets, it is important for divorcing parties to consider the tax basis of each asset. The spouse receiving an asset with a lower basis may face higher capital gains taxes upon selling it in the future. The parties should aim for an equitable division of assets with consideration for their tax consequences.

Capital Gains Can Be Avoided, Reduced, or Deferred with Certain Strategies

It is important to work with a knowledgeable attorney and a financial advisor when developing plans to distribute assets with capital gains implications. Experienced advisors can help ensure that issues are managed to establish fair distributions that avoid unnecessary tax burdens. Strategies might include:

  • Retaining joint ownership of a primary residence until eligibility for the capital gains tax exclusion is established.
  • Using a Qualified Domestic Relations Order to defer tax obligations on retirement assets distributed in divorce.
  • Depending on the couple’s tax situation, it may be advantageous to transfer assets before or after the divorce is finalized. Consider consulting with a tax advisor to determine the optimal timing.
  • Holding assets until they qualify for the lower long-term capital gains tax rate.
  • Consider the tax consequences of different types of assets. For example, assets with built-in capital gains may be better allocated to the spouse with lower income or capital gains tax rates.
  • If the marital home is being sold as part of the divorce settlement, consider the capital gains exclusion for primary residences. Married couples filing jointly can exclude up to $500,000 in capital gains ($250,000 for single filers) if they meet certain ownership and use requirements.

In addition to tax issues, your property distribution plan also should consider each spouse’s need for liquidity and coordination with retirement plans.

Professional Advice Can Make a Significant Impact at All Stages of the Divorce Process

Many divorcing couples who have retained a cordial relationship try to save money by negotiating their own property settlements. However, if they don’t know how to handle issues such as capital gains obligations, their attempt to save on legal fees could cost them much more in the long run. An experienced professional can pinpoint potential difficulties and help develop plans that create a truly equitable and economical solution.