The Tax Consequences of Divorce

The Equitable Division of Assets

Colorado is an equitable distribution state where you and your spouse must divide your assets according to "whatever is fair" according to the family courts. Equitable division of assets is often a 50/50 split, but you and your soon to be former spouse can also agree out of court and decide how to split assets. The court will generally go along with the proposed agreement if it is fair. 

The Federal Tax-Free Transfer Rule Usually Applies

According to IRS Code Section 1041, you can divide most assets, including cash, between you and your soon-to-be-ex without any federal income or gift tax consequences. When an asset falls under the tax-free transfer rule, the person who receives the asset takes over its existing tax basis (for tax gain/loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

Example 1: You agree to give your ownership interest in your primary residence and some cash to your spouse in exchange for keeping all the stock in your incorporated small business. You also agree to let your soon-to-be-ex keep your vacation home in exchange for some stocks held in taxable brokerage firm accounts and more cash. These swaps are tax-free thanks to the tax-free transfer rule. The existing basis and holding periods for the homes and stocks carry over to the spouse who winds up owning them.

Tax-free transfers can occur before the divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they are made "incident to divorce," which means those that occur: within one year after the date the marriage ends; or within six years after that date as long as they are made pursuant to your divorce or separation agreement.

Even When Tax-Free Transfer Rule Applies, There Are Still Tax Implications

The spouse who winds up owning an appreciated asset (fair market value in excess of tax basis) must recognize taxable gain when it is sold -- unless some exception applies, such as the exclusion for gain on sale of a principal residence.

Example 2: Your divorce settlement calls for your spouse to receive all your long-held Apple shares. Thanks to the tax-free transfer rule, there's no tax impact when the shares are transferred. Your ex keeps on rolling under the same tax rules that would have applied had you continued to own the shares (carryover basis and carryover holding period). When your spouse ultimately sells the shares, he or she (not you) will owe any resulting capital gains taxes.

Heads Up: When you are the one who ends up with appreciated assets, you're on the hook for the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that have not appreciated.

Retirement Accounts Are Big Exception to Tax-Free Transfer Rule

The tax-free transfer rule definitely does not apply to tax-advantaged retirement accounts like IRAs or accounts with employer-sponsored retirement plans. You must jump through some hoops to get tax-free treatment if you transfer all or part of your account balances to your ex in divorce. For qualified plan accounts like a 401(k), your divorce papers must include language establishing a Qualified Domestic Relations Order (QDRO). Then your ex will be responsible for any taxes on his or her share. A different procedure is used to split up your IRA money without getting socked with taxes on funds that go to your ex. See my earlier article on that subject here.

Like any major financial transaction, a divorce can have important tax implications. If you have a healthy net worth or high income, seek advice from a tax professional with experience handling divorces. Be warned: many divorce attorneys are not up to speed on tax issues.

Article by Bill Bishcoff

Located in Denver (303) 299-9484 and Fort Collins (970) 472-1838, The Harris Law Firm is Colorado's largest family law firm.  Focusing exclusively on Colorado Divorce and Colorado Child Custody and Support, the firm's philosophy is to work with you to resolve your legal matter in the best way possible. When you consult with one of our attorneys, the expert legal advice you receive will help you understand your rights and options according to Colorado law. And when you retain this AV rated firm, the many years of combined experience provided by your legal team will ensure that the resolution of your case is handled in the most organized, timely, cost efficient and effective manner possible. If you want to limit conflict and protect your rights, call us today to schedule a private consultation in our Denver or Fort Collins offices. Call us at 303 299 9484 or send us an email at info@harrisfamilylaw.com.

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