You may have heard people say that no good marriage has ever ended in divorce. No divorce has ended without at least a modicum of financial turmoil, either.
Some of your clients might have avoided the pure hardship of suddenly having less income and higher expenses. However, others are very likely to suffer headaches while dividing complex assets such as real estate and investment portfolios, or property that carry deep emotional attachment such as a family home or high-value collectibles.
Many experts advise that the most amicable way to wind through a divorce settlement is to treat it like a business negotiation. Business partners buy each other out all the time, and it makes sense to exchange marital assets for cash or sell them outright and split the profit. However, this opens the door for capital gains taxation and depending on the nature, timing, and value of the liquefied assets, the liability could be crippling.
Do Your Clients Owe Capital Gains Tax if They Buy Out Their Ex?
In community property states such as California, divorce settlements must equally divide all assets accumulated during your marriage or purchased with commingled funds. Generally speaking, the dollar-for-dollar exchange when you transfer your share of asset ownership during divorce proceedings is not income or a capital gain. The Internal Revenue Code §1041(a) treats these transfers between divorcing partners as tax-free gifts, as long as they occur:
- Before or during the divorce proceedings
- At the time the divorce is finalized
- Within the first year after the dissolution
- Within six years of the dissolution if the transfer is “incident to the divorce” and specified in the divorce settlement
The real trouble often comes years after the client has assumed ownership of the asset, and the attempt to sell it. Here is a look at three scenarios with varying degrees of post-divorce capital gain realization.
Real Estate
Divorcing couples that profit from the sale of their primary residence can exclude up to $500,000 when filing jointly ($250,000 when filing single) from capital gains realization with a few stipulations. However, this exemption does not apply to secondary residences, vacation homes, or investment real estate.
Imagine that your client and their spouse bought a weekend beach house for $500,000, now worth $1 million. Your client could buy their spouse out in the divorce for $500,000, which would completely release him or her from ownership liability and not qualify as a taxable gain in the present or future. Then when the client goes to sell the beach house for the current value of $1 million, they alone would owe capital gains tax on the full appreciation of the property totaling $500,000.
Investment Portfolios
Liquid assets, such as mutual funds, stocks, and REITs, held for long periods to build wealth, can have sharp consequences for whoever comes out of the divorce with sole ownership. Like the asset transfer of property, the initial buyout based on the current value of the investment is not subject to capital gains tax.
For example, say that your client and their spouse purchased $50,000 worth of stock shares early in their relationship and held onto them throughout the long term of the marriage. Assume the present total value is $1 million, and the divorce settlement decrees that their spouse relinquishes ownership of his or her half for $500,000, tax-free due to IRC§1041(a).
Now, if your client continues to hold all of the stock for a few more years, they might sell it for a total of $1.25 million. They will realize a capital gain equal to the full appreciation from the original purchase price. At an estimated capital gains tax rate of 40%, their tax liability would be $480,000.
How Can a Deferred Sales Trust Help?
The Deferred Sales Trust is a tax strategy that uses the proceeds from the sale of virtually any asset to establish a trust held by a certified, third-party Deferred Sales Trustee. In return, your clients can receive an installment note with flexible repayment terms and the option to invest 100% of the funds so long as they remain in the trust.
The IRS Installment Method of tax treatment allows your clients to defer capital gains tax payments until they begin receiving scheduled distributions of principal from the original trust amount. Then, they only pay the capital gains tax on the principal included in the payment at the current capital gains tax rate at the time of receipt. Of course the amount of any interest included in the scheduled distribution is taxed as ordinary income.
If appropriately structured, a DST can allow them to defer the capital gains taxes due on the sale of either of the two scenarios discussed indefinitely. Furthermore, your client has the option of setting up cash flow payments made up of interest and principal and these distributions are taxable at the lower combined tax rate.
Selling an appreciated asset to satisfy a division of assets.
It is not uncommon especially when the family home or other real estate is involved to have to sell the asset so that the cash proceeds can be divided between the parties. If that real estate is highy appreciated, both parties may be staring at a significant capital gains event.
Sale of the Primary Residence
If the couple had resided in the home for any two of the five years preceeding the sale, each spouse would be eligible to exclude $250,000 of their individual profit from the capital gains tax. this is a great benefit but if often not enough. Suppose you bought your home for $500,000 and at the time you are divorcing and looking to sell the house, the value of the home is $2,000,000. Each spouse would be expecting $1,000,000 at the conclusion of the sale…. or would they? With each spouses $1,000,000 share, their individual cost basis is $250,000 (or half of the original purchase price). The IRS Section 121 exclusion permits them to exclude another $250,000 from taxation. This however leaves them with a taxable gain of $500,000 each, which could result in approximately $150,000 in taxes due per spouse.
By using the DST as part of the sale, either or both spouses could fully defer the capital gains taxes on the sale leaving significantly more capital for reinvestment to generate a higher income, among other things. Furthermore, it is possible that in consulting early with your DST Trutee, it is possible we could structure your DST in a way that you could receive part of your proceeds tax free to buy a replacement home, while allocating the rest of your tax deferred sales proceeds to generate a supplemental income.
Sale of Investment Property
With the sale of investment property, you are not eligible for the Section 121 exclusion so an even greater percentage, in fact the entire appreciation of the property would be subject to capital gains. Also dont forget that any amount of depreciation you have taken against the property will also be subject to taxation through ‘recapture’.
Once again, the DST could help either or both spouses to defer both the capital gains and the depreciation recapture taxes, leaving again, more capital for reinvestment to generate a higher amount of consistent income, faster wealth accumulation, or a combination of both.
Request a Free DST Analysis
For more information on how a Deferred Sales Trust can increase profits and provide a vehicle to continue building net worth, contact us online or call (714) 581-5376 and speak to a DST specialist today.