When a divorce happens, there are often major financial consequences and some important tax issues too. Here are the tax rules that generally apply when a couple’s assets are split up in a divorce property settlement.
How assets are split up in a divorce depends largely on where the divorcing couple lives. The following nine states are community property states: California, Texas, Washington, Wisconsin, Arizona, Nevada, New Mexico, Louisiana, and Idaho. In these states, the general rule is that community property assets (that is, assets accumulated by the couple during their marriage) are considered to be owned 50/50. Assets that were owned by one spouse before the marriage, or that were received by one spouse as a gift or bequest during the marriage, are generally considered to belong solely to that person.
All the other states except Mississippi are so-called equitable distribution states. In these states, the general rule is that the divorcing couple’s assets are divided according to “whatever is fair” in the opinion of the divorce court. As a practical matter, this often works out to be a 50/50 split. However, a 50/50 split is not mandated by law in these states. (In contrast, a 50/50 split generally is mandated by law in the nine community property states.) Of course, a divorcing couple can also agree out of court on their own version of “what is fair.”
In Mississippi, the general rule is that each spouse walks away with the assets that are titled in his or her own name.
Now let’s talk about the federal tax aspects of divorce. The general rule is that the division of property, including cash, between divorcing spouses has no immediate federal income tax or federal gift tax consequences. Why? Because Section 1041(a) of the Internal Revenue Code generally mandates tax-free treatment for transfers between spouses of real estate, personal property, investments held in taxable accounts, business ownership interests, and similar assets both before the divorce and at the time the divorce becomes final. Such transfers are considered gifts between spouses. As such, no federal income tax or federal gift tax is due.
This same tax-free treatment also applies to post-divorce transfers between ex-spouses if they are made incident to divorce. Transfers incident to divorce mean those occurring within:
When a transfer falls under the tax-free transfer rule, the spouse (or ex-spouse) who receives the asset takes over the existing tax basis in the asset (so a carryover basis rule applies). The spouse who receives the asset also takes over the existing holding period for the asset (in other words, a carryover holding period rule applies).
Important: The tax-free transfer rule doesn’t automatically apply to tax-advantaged retirement accounts (you must jump through some hoops to get tax-free treatment). Also, the tax-free transfer rule is inapplicable to taxable investments to the extent of accrued ordinary income (more on that later). Finally, the tax-free transfer rule doesn’t apply when the spouse who receives the asset is a nonresident alien.
Although the tax-free transfer rule applies to most divorce-related asset transfers, the federal income tax implications are still extremely important. Why? Because the spouse who winds up owning appreciated assets (fair market value in excess of tax basis) under the tax-free transfer rule must recognize taxable income or gain when those appreciated assets are sold (unless some exception applies, such as the exclusion for gain on sale of a principal residence).
Key Point: When one spouse ends up with 50% of the couple’s assets in the form of cash while the other person ends up with 50% in the form of appreciated assets, guess who got the short end of the stick? The person who received the appreciated assets, that’s who. For this reason, divorce property settlements should be based on net-of-tax values (fair market value of assets reduced by any built-in tax liabilities). That way, the agreed-upon split (50/50 based on net-of-tax values, or 60/40 based on net-of-tax values, or whatever) won’t create any unexpected or unfair tax outcomes for either party.
Under the tax-free transfer rule, divorcing spouses can usually make tax-free transfers of investments held in taxable accounts (or in a safe deposit box or under a mattress for that matter) while they are still married or when the divorce becomes final. The same is true for post-divorce transfers between the parties, provided they are made incident to divorce, as explained in more detail in the right-hand box.
Remember: After a tax-free transfer, the recipient spouse’s tax basis in the investment is the same as before and so is the holding period.
Example: Let’s say your divorce property settlement calls for your soon-to-be-ex-spouse to receive all of your long-held stock shares. Assume the tax-free transfer rule applies. Accordingly, there’s no immediate tax impact on either you or your spouse when the shares are transferred. Instead, your spouse just keeps on rolling under the same tax rules that would have applied had you continued to own the shares (that is, carryover basis and carryover holding period).
The same results would apply if the stock shares were:
That’s the catch. When you are the one who winds up owning appreciated investment assets, you will ultimately owe the built-in tax liability that comes attached to those investments. The bigger the appreciation, the bigger the tax bill. So from a net-of-tax point of view, appreciated investments are worth less than an equal amount of cash or other assets that have not appreciated.
Key Point: You and your soon-to-be ex-spouse should use net-of-tax figures to arrive at an equitable property settlement. For instance, let’s assume the objective in this example is to divide everything 60/40 in favor of your spouse. In arriving at the 60/40 split, the value of any appreciated investments held in taxable accounts should be reduced by the applicable built-in tax liabilities.
According to the IRS, the tax-free transfer rule generally applies only to what might be termed “capital-gain assets.” (IRS Revenue Ruling 87-12 and IRS Field Service Advice 200005006)
In contrast, when you transfer investments with accrued ordinary income (for example, taxable bonds between interest payment dates, stock shares after the ex-dividend date but before the dividend payment date, U.S. Savings Bonds with accrued interest, and the like), you are taxed on the accrued ordinary income as of the date of the divorce-related transfer.
Special care is required for post-divorce transfers of appreciated assets to an ex-spouse. Such transfers are tax-free only if they are considered incident to divorce.
Within one year after the divorce, transfers automatically pass this test. For a later transfer to be considered incident to divorce, it must be shown that the transfer is related to the cessation of the marriage. This generally means the transfer must:
If you plan to transfer appreciated assets to your ex-spouse more than one year after the divorce, the divorce papers should clearly identify such transactions as being part of the property settlement. Otherwise, you could be treated as making a taxable sale or a gift to your ex-spouse. This could result in a tax bill or it could diminish your $12.06 million federal gift tax exemption for 2022 (up from $11.70 million in 2021).
Please contact Richard Morris via our online contact form for more information.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.