During a divorce tax issues are commonly overlooked, often even by divorce attorneys. This series of articles by Littleton Divorce Attorney Bonnie Shields discusses the tax effects of divorce. Part 1 of this series specifically looks into the tax ramifications of property transfers that happen as a result of a divorce.

Property Division During a Divorce

In each divorce case the courts must divide marital property between the parties. This process is guided by statute and can be imposed entirely by the court, but more frequently the division of assets is handled by the parties through a mutually agreed upon settlement. The court will typically approve the property division settlement, which is then included as part of the divorce decree. Upon entry of the decree the parties will transfer assets between each other according to the decree. Often this means transferring assets such as stocks and other investment portfolios, real estate, cash and retirement accounts.

Taxation of Assets Transferred in Divorce

Usually transfers of property between married persons are not taxable, however, many property transfer relating to divorce happen after the couple is no longer legally married. When dealing with non-married individuals two types of taxes might commonly apply when transferring property. One such tax is called the gift tax, which imposes a tax on transfers of property in excess of $13,000. The other such tax is the capital gains tax, which imposes a tax on the appreciation in value of property when property is transferred. Luckily, the tax code creates exceptions for these taxes in the context of divorce.

Under Internal Revenue Code Section 1041, to avoid the imposition of capital gains tax, the transfer must be made to a former spouse and “incident to divorce.” The term incident to divorce means the transfer should be made within 1 year of the end of the marriage, and must be related to the cessation of the marriage. Similarly, code Section 2516 allows for the transfer of property between former spouses without application of the gift tax if the transfer is subject to a written settlement agreement and occurs within the 3 year period starting 1 year prior to the dissolution of marriage.

Together, these code sections allow a divorced couple to transfer property between one another without the imposition of heavy tax burdens as would otherwise happen between unmarried individuals. But this isn’t the end of the story.

Coming Out Ahead of Divorce Taxation

I’d venture to say most divorce attorneys, although not specialized in tax law, are well aware of the preceding laws or at least understand that transfers occurring pursuant to a divorce decree are not taxable. But there is much more to understand here than the basic rule, and this is why you should seek a truly skilled divorce attorney.

Even though no taxation happens when transfers of property occur between former spouses as described above, there can be taxes that arise from the transaction later. Let’s say a couple has $100,000 in cash and $100,000 in stocks that were originally purchased for $20,000. Clearly those stocks have performed well and may at first glance appear to be the more desirable option, but consider how capital gains taxes will apply. In the divorce husband takes the stocks and wife takes the cash. The transfer itself complies with the internal revenue code rules and therefore no taxes are incurred by either party at the time of the transfer.

Husband decides to sell the stocks because he needs the liquidity. Upon the sale of the stock husband must recognize capital gains taxes on the appreciation of the stock all the way back to the date the couple purchased it. The stock represents a capital gain of $80,000 (the sale price minus the original purchase price). Capital gains are taxed at a rate of 15% for most people, so husband must pay $12,000 in taxes. Essentially, because of the capital gains tax built into the stocks, they were worth $12,000 less to husband and wife than the fair market value. Wife clearly got the better deal by taking the cash.

Littleton Divorce Attorney Bonnie Shields understands these nuances in the tax system and can use them to help you avoid common mistakes in a divorce property settlement. Contact Littleton Divorce Attorney Bonnie Shields today for a free consultation.