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 two scenarios with varying degrees of post-divorce capital gain realization.
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.
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 from the original trust amount. Then, they only pay tax on the principal included in the payment at the current capital gains tax rate at the time of receipt.
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 can set up cash flow payments made up of interest and dividends earned by investing the principal, and these distributions are taxable at the lower income tax rate.
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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.