Tax Considerations in Divorce Division of Assets

In negotiating a divorce settlement, it is important to consider the after-tax values of the assets that are being divided.  Tax rates vary according to the kind of account or asset.  All of the tax considerations are also predicated on the six-year allowance of any transfers pursuant to divorce (IRC Section 1041).

There are several categories of assets:

Cash

There are no tax implications for transferring even large amounts of cash between spouses if done within the IRS timeframe (within 6 years of final decree) and compliant with the divorce decree or Marital Settlement Agreement. 

Sometimes, as part of the division of assets, cash (or securities) are transferred to third parties such as the children, a Supplemental Needs Trust, ABLE account, someone joined to the divorce, etc. Once the transfer to any individual exceeds the annual exclusion amount ($19,000 in 2026), a gift tax may be triggered requiring the giver to file a gift tax return.  It is important to consider the implications of cash transfers to individuals other than a spouse.

Real Estate

If the marital home is jointly owned and the sale triggers capital gains, each spouse is eligible for a $250,000 tax exemption on their share of the gain, allowing for a total exclusion of $500,000.  To qualify for the exemption, however, the home must have been your primary residence for two of the past five years.

If one spouse has remained in the house or is going to remain in the house until the sale and have sole use and possession, the divorce decree must expressly specify that the other spouse will retain their ability to take the capital gains exclusion as incident to divorce. The Marital Settlement Agreement or divorce decree must stipulate that “the nonresident spouse retains an ownership share of the home.”  As long as one spouse continues to make the home their primary residence, then both are allowed the exemption.  Both parties do not need to be on title to the home. 

In divorce, only if stipulated in writing in the divorce document, will the IRS allow an exception for not meeting the 2 years out of 5 requirement. 

Rental property held for investment have tax implications to consider for either a buyout or sale.  The accumulated depreciation realized each tax year throughout the rental period must be paid when the property sells. If a buyout from one spouse to another is in order, the tax on accumulated depreciation (approximately 25%) is usually significant enough to consider when valuing the amount of the buyout. If the property were sold, each spouse would be obligated to share in the tax on accumulated depreciation unless the property was a business asset of only one spouse and not recognized as a joint asset on the preceding years’ tax returns.This requires the assistance of a tax preparer to identify the depreciation realized through the years,to calculate the taxes due and who is obligated to pay them.

Brokerage Accounts

The true value of a brokerage account depends largely on how long the assets have been held and how much they have appreciated or depreciated.  Two accounts of the same value can have substantially different tax outcomes when sold, based on the cost basis of the underlying assets and when they were purchased.

Ordinary income tax rates are applied to gains on assets held one year or less and this could be upwards of 37%. Long-term capital gains tax rates of 0%, 15% or 20% (depending upon one’s Adjusted Gross Income). In addition, with long-term capital gains, the gains may be subject to a net investment income tax of 3.8% if the modified adjusted gross income is above certain thresholds.  It matters who is receiving the assets held less than one year or more than one-year and what that spouse’s income level is.

Even if a portfolio is divided equally, the higher wage earning spouse may end up with a lower after-tax value. If the spouses want to divvy up the assets to arrive at a more equal footing of after-tax potential value, then strategic division of assets is needed.

But circumstances may change.  The spouse who was not earning at the same level, but has the potential in the future to do so, may then may a short-term decision that could backfire in the long-term. Careful consideration must be made if the assets are not divided without considering the tax implications and when tax-affecting the various positions in a portfolio.

Depreciated assets offer an opportunity for tax loss harvesting in which the spouse who receives the depreciated assets can offset any realized gains or ordinary income with the recognition of losses in a portfolio.  This often gets overlooked but can be beneficial to either party, depending on their situation

Other considerations are private equity investments which may be relegated to a commitment for additional capital contributions.  These can impact the cost basis that is currently showing in unrealized gains/losses in certain positions. 

Retirement Funds

Even though 401(k)s, IRAs, and pensions are individually held, any funds accululated during the marriage are nevertheless considered marital property. A spouse with greater overall retirement assets may need to transfer some of those funds to the other spouse’s retirement account according to specific rules.

401(k), 403(b)

Qualified accounts under ERISA, such as 401(k)s, will require a separate court order called a Qualified Domestic Relations Order (QDRO).  The assets are transferred from one account to the other like any rollover, and the assets will grow in the new owner’s (alternate payee’s) name. 

If the Plan allows, when dividing qualified accounts, the Divorce allows for the alternate payee to make an early withdrawal of funds either at the time of division, or later, or both depending upon the Plan’s restrictions.  While receipt of an early withdrawal will not be subject to the 10% penalty typically assigned to withdrawals before the age of 59 1/2, the alternate payee receiving their share of the division, will pay ordinary income tax on the traditional portion of the withdrawal. Furthermore, the withdrawal is subject to withholding (currently 20%) and taxed at both the federal and state ordinary tax rates.

Deciding to take an early withdrawal from these plans does have a major tax impact and should be keenly evaluated before making such decisions. 

If the alternate payee is not taking out any withdrawal, there is no immediate tax implication for the division of the account.

An IRA can be divided without tax consequences as long as it’s spelled out in the divorce decree. But any subsequent withdrawals before the age of 59 ½ are subject to an early-withdrawal penalty.

A Roth IRA has different tax implications than a traditional IRA, and this distinction has a significant impact if one party receives the Roth account and another the traditional account or if the accounts are not divided evenly. Roth IRAs should be divided equally and separately from the traditional IRAs, whether only one party has a Roth or if both have Roth IRAs.

Pensions

A pension benefit earned during the marriage is typically considered joint marital property. Any joint value is typically divided in one of two ways. The spouses can agree to share the monthly annuity payments during retirement, as stated in the divorce decree. If awarded a share of the spouse’s pension, the alternate payee will need to have it segregated via a QDRO. Any payouts received from the pension would be treated as ordinary income. 

An alternative method is to calculate the net present value of the pension and offset the other retirement assets against the pension. The spouse with the pension would keep the entirety of the pension and transfer assets of equivalent value at the current time to maintain the pension for themselves.  However, this is not always an equivalent tradeoff since most pensions are guaranteed payable for life whereas other assets may not be sufficient to support a 30-year retirement.  Furthermore, pensions often have Cost of Living features which make them increasingly more valuable than other retirement assets which may be depleted due to sequence of returns risks if there is a bear market at any point in retirement. 

Collectibles

Art and other collectibles acquired during the marriage is typically divided equally but may be selected by the parties for sentimental reasons without an equalization payment. However, if something was a gift, that is the property of the recipient and not subject to consideration for division.

The cost basis of collectibles is the original purchase price, and with appraisals, fair market value can be established.  There are various capital gains taxes if any items are sold, but if simply awarded to one or the other spouse, there is no tax implication.

Jointly Held Businesses

A business is often seen as community or marital property and will likely be divided according to the statutes. 

A business may be sold outright and the net proceeds disbursed similar to other financial assets. The proceeds would be subject to all federal and state taxes.

An alternative would be one spouse buys out the other spouse either in cash or in assets of equal value.  Agreeing on the value of a business is best managed through a formal business valuation.  The spouse who sells a portion of the business, however, would likely owe taxes on any capital gains, and that will diminish the overall value of the business. 

The buyer of the business would immediately have a step up in cost basis based on the valuation at the time of the buyout, and this could enhance the overall value of the business in the future. 

Of all of the assets to be divided in divorce, valuing and selling a business has complex tax implications and should be approached with a team of specialists.

This article does NOT constitute legal or tax advice and is for general informational and educational purposes ONLY. Prior to making any decisions, seek legal counsel from a licensed attorney or tax specialist.