Divorce and the Tax Man

April 15th is approaching and if you’re in the midst of or planning a divorce there are things you need to know before you start dividing up the marital estate. Sometimes, cash needs to be made available in order to arrive at equitable distribution of assets and when that happens, assets need to be sold. This can trigger capital gains; once again it is crucial to understand how each asset works in the bigger picture.

One of the biggest issues that divorcing people face is potential capital gains on non-retirement assets such as stock, bond or mutual fund portfolios. The biggest chunk could come from the potential sale of the marital residence or vacation and investment properties. Let’s discuss the marital residence for example. If the house is sold before the divorce is final, the still married couple has a joint $500,000 exemption from capital gains. So, say the house was purchased for $600,000 and $400,000 of capital improvements were made (dormer, kitchen, bathrooms, roof, etc.) raising the cost basis to $1,000,000. The house is sold for $1,500,000. There are $500,000 of capital gains. As a couple, they are exempt so there is no tax to be paid. However, if one person assumes ownership of the house and then sells it post divorce, that individual only has $250,000 of exemption and therefore will owe tax on $250,000 of capital gain. $1,500,000 – $1,000,000= $500,000-$250,000=$250,000. At a rate of 15% there will be $37,500 of tax owed.

When you have non-retirement assets such as stocks, bonds or mutual funds that have increased in value since the date of purchase, there may be tax ramifications here as well. If a brokerage account is being used to provide liquidity in the division of assets it is crucial to know the cost basis of each asset in the account. The technique of tax harvesting can be a useful tool when deciding what assets to sell in whole or in part. The process of selling these non-qualified positions, using a last in first out or LIFO method can help reduce the potential capital gains. Also, some assets may have long term unrealized loss and can be used to offset potential gains. Speaking with your financial advisor and accountant will assist you in making these decisions.

Lastly, different types of deferred compensation can pose tax problems as well. For example, if one member of the couple has been granted restricted stock units (RSU’s) or owns stock through an employee stock option plan (ESOP) things get a bit more complicated. It’s important to understand what these assets are, how they work, and what choices can be made in order to deal with them during negotiations. Part of the issue is that these assets are non-transferrable in kind unlike other types of stocks, bonds or mutual funds would be. They have been given to Spouse A by virtue of employment and if it is determined that Spouse B is entitled to a portion of the value they may have to be converted or sold in order to make that happen. The sale triggers a taxable event which, as of the current tax code, is 22%.

There are many things to consider in equitable distribution of assets especially when it comes to taxable implications. Working with a CDFA during the process will help you identify these assets, the issues that may be inherent in them and how to proceed with the best scenario for equitable distribution.