Divorce and Responsibility for Capital Gains

By Jeff Franco J.D./M.A./M.B.A.

Once your divorce is final, your responsibility for paying income tax, which includes the tax on capital gains, and filing annual tax returns continues. In most cases, the IRS doesn’t treat the splitting of marital property as a taxable transaction that requires the payment of capital gains tax, but there are other capital gain and loss implications you should be aware of.

Tax-Free Transfers

If you own property with your spouse, it’s likely that you will reach an agreement on how to split the marital assets and document it in your divorce agreement. Luckily, transfers of marital assets between spouses that are part of a divorce agreement aren’t transactions in which you must recognize gain or loss, meaning no capital gains taxes are due. Moreover, it’s irrelevant how you split the assets or if one spouse receives more than the other. The only time you may have to report an asset transfer on your tax return is when your spouse is a nonresident alien, the asset transfer is made through a trust or for certain stock redemptions.

Past Tax Years

When you make the choice to file a joint return, you and your spouse are jointly liable for all taxes. Finalizing your divorce doesn’t extinguish your responsibility for those past tax returns until the statute of limitations expires. Provided your joint returns are accurate and complete, the IRS has three years from the time of each return’s filing to conduct an audit and increase the amount of tax you owe. However, this joint liability also extends to income taxes you accurately report, but fail to pay. For example, suppose you filed a joint return last year that reports a $10,000 income tax bill because of a capital gain. If the balance remains unpaid after your divorce, the IRS can collect the full amount from you or your former spouse – not just 50 percent of it.

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Future Tax Years

Once your divorce is final, you can no longer file a joint return with your former spouse. Therefore, your filing status will change to single or, if you have dependents and maintain a home, possibly head of household. With either filing status, you are solely responsible for the income tax you report on a return. This includes the capital gains taxes you owe resulting from the sale of your separate investments and personal property.

Offsetting Future Gains

You should also consider the potential tax savings that unused capital losses can provide you with in future years when no longer filing a joint return. The tax law allows you to reduce future capital gains with the excess capital losses you accumulate from prior tax years. However, when you incur these capital losses during your marriage, there are two ways to allocate them between you and your former spouse. If you incur the losses on assets you own together, such as in the case of a brokerage account in both your names, you can use half of the capital losses on your future tax returns. However, if you each maintain separate brokerage accounts during the marriage, no allocation is necessary and you only carry over the losses from your separate account, regardless of whether you reported capital losses from that account on a joint tax return.

Relief from Joint Liability

There are circumstances when the IRS can grant you relief from joint liability for the taxes you owe on a prior joint return. If the original return incorrectly reports the capital gain and additional taxes are due, the IRS can separate the liability and only require you to pay half of the tax. However, if you’re unsuccessful in obtaining a separation of the liability and the capital gain is incorrectly reported, or correctly reported but your former spouse refuses to make any payment, you can request equitable relief to reduce or eliminate your responsibility for paying the tax.

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How to Handle Previous Refunds for Taxes in a Divorce

References

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