Although often ignored, the cost basis in taxable accounts and for property is critical to a long term efficient asset division in divorce.
What is cost basis? Cost basis, sometimes referred to as just ‘basis’ or ‘tax basis’, is generally the original cost (purchase price) of a stock, bond, mutual fund, other financial security or property. In the most simple terms, taxable capital gain is sales price less cost basis.
Here’s an example:
Husband and Wife have equivalent income and three assets:
- $200,000 of Land
- $150,000 of Cash held in savings (secured by and borrowed against the land) and
- $100,000 in a Retirement Account (non-Roth)
Husband gets the $150,000 cash and Wife gets the land (Land value of $200,000 less debt of $150,000 = $50,000) and the $100,000 retirement account. Thus, each gets $150,000.
Nope. What about basis? The basis of the Land is only $10,000. If wife sells the land, she’ll be taxed on the difference between the value and the basis, at capital gain rates of either 15% or 20% depending on her income and assuming the asset has been owned for more than one year (for primary home sales there is a $250,000 or $500,000 capital gains tax exemption, see our “A House Divided” blog post).
The IRS doesn’t care that there is a loan on the property. Capital gain for tax purposes is the sale price less purchase price. More precisely, capital gains are also reduced by selling costs and improvements (ignored here for simplicity).
The capital gain in this example is $200,000 – $10,000 = $190,000. 15% of $190,000 is $28,500. So, instead of the land being worth $50,000 the “value” of the land to the wife is $21,500, not $50,000.
The wife will also be taxed at ordinary tax rates when she withdraws money from the account. If she needs to withdraw immediately she could have a rate as high as 39.6% depending on her income. Done property, she’ll avoid the 10% penalty but she’ll only have one chance to do so. Whether or not you should tax adjust (discount) retirement accounts in divorce depends on how close the spouses are to age 59.5 and when those funds are needed for income.
More on Capital Gain Tax Rates
The IRS currently has a special rule regarding federal capital gains taxes for low income individuals, those whose income is taxed in the 10-15% tax brackets (up to $36,900 in 2014, $49,400 if the spouse can file as head of household post-divorce). There are exceptions, but if a spouse qualifies he or she should be awarded low basis assets e.g. those assets with significant capital gains. He or she will pay NO taxes on long term capital gains. If long-term capital gains take you into a higher tax bracket, only the gains above that threshold will be taxed at the higher rate. This doesn’t avoid state capital gains rates, which may apply.
For example, a low income spouse who is awarded a low basis taxable account has the opportunity to rebalance the account allocation in a way that reflects that spouse’s unique goals and risk tolerance. Since the rebalance will require the sale of existing low basis securities (stocks, bonds, funds, etc.) the tax consequence of those sales may be lowest in the first year after divorce, before that spouse has a chance to seek higher wages.
Conversely, newly single spouses who will have income greater than $200,000 should avoid taking low basis assets in divorce to avoid an additional 3.8% on investment income – the Medicare Surtax. And further, long term capital gains rate for single tax filers with income over $400,000 income is 20%, not 15% as described above.
Divorce Planning of Austin helps couples and individuals project and analyze their post-divorce income, expenses, asset protection needs and the potential tax impact of divorce. We save thousands of dollars with intelligently designed asset division and post-divorce financial planning.
Silicon Hills Wealth Management and Divorce Planning of Austin work with clients and their attorneys to help insure that financial accounts are divided in the most efficient manner possible. Please contact Pam Friedman, CFP®, CDFA™ at firstname.lastname@example.org.
Asset protection plans should be developed and implemented well before problems arise. Due to the fraudulent transfer laws, asset transfers that occur close in proximity to the filing of a lawsuit or bankruptcy can be interpreted by the court as a fraudulent transfer. Proper structuring of these assets is imperative please seek proper legal and tax advice prior to engaging in re-titling/structuring of any assets. Please note that laws are subject to change and can have an impact on your asset protection strategy.
Neither Silicon Hills Wealth Management nor Divorce Planning of Austin are accountants and do not provide tax advice. Please consult with your tax professional regarding your specific circumstances.
Hypothetical results are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
Investment advisory services offered through Silicon Hills Wealth Management, LLC, a registered investment advisor.