Under current tax law, some tax carryovers can be negotiated as part of a divorce settlement. Thoughtful family law attorneys recognize that these carryovers, much like property, are considered to have inherent value and should be included in negotiations when assets and liabilities are divided. Because of the potential tax implications that come with how carryovers are allocated, attorneys must understand the different types of carryovers and how they are treated in order to properly describe the potential impact to their clients.
Understanding Tax Treatment of Carryovers
Tax carryovers come in many different forms:
- Capital losses
- Net operating losses
- Passive activity losses
- Charitable contributions
- Alternative Minimum Tax (AMT) credits.
It's important to understand that tax carryovers related to separate property (generally speaking, property acquired by one spouse prior to the marriage, or gifts or inheritances received by one spouse at any time) receive different treatment than those related to marital assets (property acquired by either spouse, or both spouses, during the marriage).
Capital Loss Carryovers
Most investors are familiar with the concept of capital gains and losses. In brief, if the sale of an investment, a piece of real estate or another capital asset resulted in a loss, you may use that loss to offset capital gains, or (in the absence of gains) to lower your ordinary income tax liability by up to $3,000 per year. Capital losses can be carried forward into subsequent years as needed, until they are fully deducted.
In a divorce scenario, capital loss carryovers are generally allocated based on separate capital gain and loss calculations for each spouse to ensure that the spouse who suffered the capital loss is able to use the carryover for tax purposes. If losses were incurred jointly by both parties, the carryover will be divided equally.
It should be noted that some states — notably New York and Missouri — have chosen to treat capital loss carryovers as marital property subject to "equitable division," rather than allocating it to the spouse who actually suffered the loss. The rationale is that the underlying capital loss arose out of the marital relationship, so the carryover should be afforded the same equitable distribution as other marital property.
Net Operating Loss Carryovers
If allowable tax deductions for your business are more than its income, your net operating loss can be carried forward to subsequent tax periods, helping reduce tax liability.
IRS regulations stipulate that net operating loss carryovers must be divided in the same manner they would have been allocated if the divorcing spouses had filed separate tax returns.
Passive-Activity Loss Carryovers
When a divorce settlement includes a transfer of passive activities — trade or business activities you and your spouse were not actively involved in, or rental activities — suspended losses are added to the tax basis of the assets being transferred.
Transfers of passive activities related to or arising from the divorce are considered tax-free gifts between spouses, so the recipient acquires the basis of the spouse who made the transfer. This means that with passive activities, suspended losses are transferred and become part of the basis for the gifted property.
To determine the basis for transferred interests in passive-activity loss carryovers, it is a good idea to request information about the holding period and adjusted basis during property settlement negotiations.
Charitable Contribution Carryovers
IRS regulations provide that any charitable contribution carryovers must be divided in the same way and in the same proportion as the charitable contributions themselves would have been divided if you and your spouse had remained married and filed separate tax returns.
If excess charitable contributions were made, spouses cannot negotiate the division of them. Instead, they must be allocated according to U.S. Treasury regulations.
Alternative Minimum Tax Credit Carryovers
Generally, AMT credit carryovers are allocated in the same manner as they would have been allocated had the parties filed separate returns. However, it is worth noting that there is no formal guidance from the IRS at this point on their treatment. It's likely the IRS would accept reasonable allocation agreements by divorcing spouses.
Include Carryover Interests in Settlement Negotiations
Working with experienced financial and tax professionals throughout every stage of the divorce proceeding is critical. This can help ensure that important decisions related to property division include the true value associated with tax carryovers so settlements are made based on complete information.
To calculate the appropriate amounts for carryovers, spouses may need to prepare "married filing separately" returns in the year when the tax loss was generated — solely for calculation purposes — and then prorate the loss between the spouses accordingly going forward. While this may seem labor intensive, it can be financially advantageous to take this step early in your property division discussions. Waiting until tax time to discuss the allocation of tax carryovers may be too late.