Tax considerations in divorce are integral to the marriage dissolution process, but often only considered in passing. At first blush, the tax issues seem relatively non-existent since Section 1041 of the Internal Revenue Code generally permits tax-free transfers between spouses that are “incident to divorce.” However, such a tax-free transfer could be a huge trap for the unwary.
The trap lies in the fact that the spouse who receives the property also receives the existing basis in that property. For example, assume $1 million of stock with a basis of $100,000 is transferred in the divorce from one spouse to the other. The transferee spouse receives the stock with the same $100,000 basis. If that transferee spouse sells the stock the day after the divorce is finalized, there could be $214,200 in federal tax due based on a 23.8% federal tax rate on the difference between the $1 million sales price and the $100,000 basis. Depending on the state, the transferee spouse also could owe as much $119,700 in state income taxes given certain state income tax rates are as high as 13.3%.
What is also often missed in this basic tax calculation is the dynamic way that taxes move over time. With a widening deficit and a new administration in power, there are now legislative changes on the horizon that could include significant increases in tax rates affecting ordinary income, long-term capital gains and dividends.
Given the potential for change, planning for a division of assets today may look different from a balance sheet perspective next year. Therefore, it is critical to think about divorce assets in a net-value approach—as opposed to gross value—while being mindful of future tax liabilities. For example, what if future capital gains tax rates go up to 39.6% plus the 3.8% net investment income tax, as President Biden proposed in his election campaign? Unlike our prior example, there would be $390,600 in federal tax due based on a 43.4% federal tax rate. In other words, the transferee spouse would receive $176,400 less upon sale due to the increase in tax rates that could possibly occur after the divorce.
When it comes to identifying, valuing and dividing assets in a divorce, the potential future tax liability typically is not taken into account in a divorce unless an asset is going to be sold as part of the divorce. Such an approach can leave one spouse with a less than equitable distribution. Rather than a division based on current fair market value less debt, a family law attorney with the help of a good wealth manager should take basis into account as well as the applicable federal and state tax rates tied to the asset.
A capital gain is realized when a capital asset, such as a business, real property or a security, is sold at a price higher than its purchase price. The profit made on the sale of this asset is called the capital gain and is included in an individual’s taxable income. To calculate the tax due, one must consider: (1) how much the value of the investment has grown, which is fair market value minus basis; and (2) how long the asset has been held.
Income from the sale of assets held for one year or less is treated as short-term capital gain that is taxed at ordinary income rates; that is, up to a 37% federal income tax plus an additional 3.8% net investment income tax, depending upon one’s tax bracket. If the asset is held for longer than one year, income from capital gains qualifies for “preferential treatment.” Under current federal law, long-term capital gains are taxed at 0%, 15% or 20% plus a net investment income tax of 3.8%, if applicable. There also may be state level taxes on the gains, which could be as high as 13.3% depending on the state.
For example, single tax filers in 2021 with taxable income below $40,400 can benefit from the 0% long-term capital gains tax rate while the 15% rate applies to incomes between $40,401 and $445,850. Single filers with incomes over $445,850 will be subject to the 20% long-term capital gains rate. In addition, the 3.8% net investment income tax applies to single taxpayers with adjusted gross income more than $200,000.
With a shift in the makeup of Congress and the White House following the 2020 elections, there is a possibility of a change in capital gains rates. Historically, the low for capital gains rates has been 12% before the 1940s and as high as 35% as recently as the 1970s. More often than not, capital gains have been taxed at rates greater than the current 20%. Currently, there is discussion around a legislative agenda that would increase the long-term capital gains rate from 20% to as much as ordinary income rates for high-income taxpayers. Thoughtful advisors would be well served to assume rates will increase in the future.
To help spouses and family law practitioners in planning for these implications, it is beneficial to examine an example involving what is often one of the most significant assets in a divorce: the principal residence.
Marital dissolution settlements usually involve the splitting (or allocation) of real property. Awareness that taxable gain is based on the cost basis attached to the property, which is not the same as purchase price, is critical. For a home, improvements and remodeling can increase basis if records are kept in order to substantiate the expense. The higher your tax basis, the smaller your tax bill will be when the home is sold.
As part of the marital dissolution process, spouses typically divide property based on the fair market value of an asset less any liabilities tied to that asset. However, failing to take into account basis and the tax liability from a future sale could be a disaster. For instance, consider this hypothetical situation:
Amy and Bob are getting a divorce and are working with their family law attorneys to address what should happen with their $2 million principal residence that has a $1.8 million mortgage. Amy wants to keep the house after the divorce and plans to live there for the next three years until all the children have graduated high school. Bob and his family law attorney have offered to let Amy keep the home if Amy gives Bob $100,000—that is, an amount equal to 50% of the $200,000 of equity in the house. Before Amy and her family law attorney agree to such a proposal, they first should examine the tax consequences of what would happen when Amy sells the house in the future. If Amy and Bob had purchased the home a long time ago for $250,000—and had taken cash out with mortgage refinancing over the years—Amy could be hit with a huge tax bill when she sells the home down the road. Assuming a $2,000,000 sale price, less Amy’s $250,000 basis, and less her $250,000 principal residence exclusion amount, Amy would owe taxes on $1.5 million in gains. If Amy takes into account federal taxes (23.8%) and state taxes (up to 13.3%), Amy will owe $556,500 in taxes when she sells the home. That would be an extremely undesirable result for Amy, especially since she only would receive $200,000 in cash after selling the home and paying off the mortgage. After taking the future tax obligation from capital gains into account, Amy and her family law attorney certainly might want to rethink Bob’s offer to let Amy keep the house in exchange for $100,000.
Being mindful and having a goal to mitigate future taxes can result in long-lasting benefits. Avoiding hidden tax traps with good planning can be priceless. As a best practice, plan today to steer clear of mistakes that are costly to correct and may carry a continued psychological burden.
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