Splitting up your assets when you part ways with your spouse isn’t just about who gets what. There are many potential tax consequences when it comes to dividing property in divorce — and it’s important to take them into consideration when negotiating a settlement agreement to ensure the outcome is fair. A knowledgeable tax professional can help you understand the tax rules, requirements, and implications to help you avoid costly mistakes.

Tax Treatment of Assets Transferred in Divorce

Transfers of assets from one spouse to the other as part of a divorce settlement are generally considered non-taxable events by the IRS. The IRS does not recognize gains or losses on property transferred between spouses if the transfer is made “incident to divorce.” In order to qualify for this tax treatment, the transfer must generally be made within one year from the date the marriage legally ended. The IRS will also recognize a transfer as being “incident to divorce” if it is “related to the cessation of the marriage” and occurs within six years from the date the marriage ceases.

The Carryover Basis

Although assets transferred in divorce receive special tax treatment, there is one caveat — the carryover basis. Specifically, the spouse who receives the asset would inherit the original tax basis with it. This means that when they eventually sell the property, they would be responsible for any capital gains associated with it.

For instance, if an asset was purchased for $300,000 during the marriage and was transferred in divorce, the tax basis in the property would be $300,000 — even if the current market value is lower or higher. In the event the spouse who was awarded the asset in divorce later sells it for $500,000, they would be responsible for paying capital gains on the $200,000 difference.

Dividing Retirement Accounts in Divorce

For many couples, their retirement accounts are some of the most significant assets that must be addressed in divorce — and they must be divided correctly to avoid tax consequences. While IRAs are transferred tax-free between spouses by the “transfer incident to divorce” process, qualified plans such as 401(k)s require a “Qualified Domestic Relations Order,” commonly referred to as a “QDRO.” Retirement accounts divided by QDROs also do not trigger taxes.

Although there are no immediate tax consequences when it comes to transferring retirement assets from one spouse to the other in divorce, any distributions taken out by the receiving spouse will be taxed as ordinary income. In addition, while the 10% early withdrawal penalty is generally waived for distributions from retirement accounts divided by a QDRO, this exception doesn’t apply to IRAs.

Capital Gains and the Marital Home

The transfer of the marital home between spouses is typically not a taxable event when transferred incident to divorce. However, the spouse who is awarded the asset should be mindful that any subsequent sale may be subject to capital gains — unless the capital gains tax exclusion applies.

In some cases, it may be more advantageous to sell the house during divorce proceedings. By selling the marital home before the divorce is finalized, you can potentially exclude up to $500,000 of capital gains from the sale under Section 121 of the U.S. Tax Code. After divorce, each spouse is limited to a $250,000 exclusion. To qualify for the exclusion, you must have owned and lived in the home as your primary residence for two out of the past five years.

Contact an Experienced Tax Professional

Divorce doesn’t only have legal implications — there are a broad scope of tax consequences that must be considered. A knowledgeable tax professional can help ensure you structure transfers properly to minimize the potential tax impact and protect your financial interests. Based in Fairfield, Connecticut, Rolleri & Sheppard CPAS, LLP offers comprehensive financial and accounting services for individuals facing divorce and assists them in making sound financial decisions as they go through the process. Contact us online or call (203) 259-CPAS to schedule a consultation.