Capital Gains Implications of Family Law Settlements
The Internal Revenue Service doesn't care if you take sole ownership of joint assets in a divorce settlement. Most transfers made according to a marital settlement agreement or decree are tax-free under the terms of Section 1041 of the Internal Revenue Code. Tax problems don't arise unless and until you decide to sell the assets you've acquired through divorce, and the IRS has a whole set of rules to determine just how much of a problem you'll have.
Although the IRS allows transfers between spouses to occur without taxation, the calendar doesn't start all over again with regard to the asset's cost or tax basis when the property changes hands. The original tax basis – what you and your spouse initially paid for the asset plus any additional investment you've made into it – transfers along with the property. For example, if you and your spouse purchased $20,000 in stock when you first got married, and if it's worth $100,000 at the time of your divorce and $125,000 years later when you decide to sell it, your cost or tax basis remains at $20,000, not the value at the time your marriage ended. You'll pay capital gains tax on $105,000, not $25,000.
Special rules apply to the marital home. If you and your spouse remained married, you could realize up to a $500,000 profit from the sale of your home without paying capital gains tax as of 2013. You must both have lived in the home for two of the last five years and one of you must have owned it for two out of the last five years. After divorce, however, your exemption eventually drops to the single rate, $250,000, but you have some time before this occurs, and the IRS makes other allowances for the sale of your residence as well.
Timing the Sale
If you and your spouse agree to sell your home and make provisions for the sale in your marital settlement agreement, it doesn't matter how much of a profit you realize. Even if it's over $500,000, you won't pay capital gains tax. You have a year from the date of your divorce to take advantage of this. If one of you keeps the home and then sells it within three years, you still get the full $500,000 exemption you would have received if you had remained married. Your exemption doesn't drop back to $250,000 unless you wait longer than three years to sell.
Realistically, you should calculate capital gains into any divorce settlement you negotiate with your spouse, particularly with assets other than your home. Subtract the tax basis from the asset's current value and apply the tax percentage to the difference. If you take stock worth $100,000 at the time you divorce and sell it immediately, and if its tax basis is $20,000, you're not receiving $80,000 in marital property. You're receiving $64,000 – $80,000 less the 20 percent capital gains tax as of 2013. Therefore, if you trade off an $80,000 cash asset to your spouse in exchange for the stock, you'll shortchange yourself. Likewise, if you give up an $80,000 asset with a $60,000 tax basis in exchange for the stock, your spouse will only be taxed on the difference of $20,000 – much less than the tax burden you'll bear. If you're taking the marital home in the divorce, consider when you might want to sell it. If you think you'll hold on to it for more than three years, factor in the fact that your residence exclusion will be cut in half.
- CalCPA Education Foundation: How Will a Divorce Affect Capital Gains on Selling of Properties?
- Rosen Law Firm: Four Things You Must Know About Divorce and Taxes
- Kiplinger: Tax Planning for Divorce
- Klausner, Bendler & Associates: Divorce, Taxes and the Marital Home
- TurboTax: Cost Basis – Tracking Your Tax Basis
- Fox Business: Six Savvy Moves to Make by the End of the Year
- Bankrate.com: Home-Sale Tax Rumor Persists
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.