Getting Divorced? Beware of Hidden Tax Traps as You Divide Assets

Tax season has officially started, and while the IRS won’t begin processing tax returns until January 27, Americans can start preparing now to avoid any surprises. For couples getting divorced, tax planning is even more critical, as they face not only the usual filing requirements but also the daunting process of dividing assets — a task fraught with tax implications that can shape their financial futures for years to come.

Each asset carries its own tax "DNA," and decisions about selling property or liquidating investments can trigger unintended consequences. Understanding the hidden tax implications of each is crucial to avoiding costly mistakes and protecting yourself from big tax bills down the line.

Take Georgia’s story, for example. After her divorce, she sold several mutual funds in her investment account to buy a new home for her children, believing it was the right move for their future. What Georgia didn’t anticipate was the $41,250 tax liability she incurred due to long-term capital gains taxes on the sale. Georgia was blindsided by this enormous tax bill, which was the last thing she needed as a new homeowner. The tax bill added significant financial stress to an already challenging situation.

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"Divorce isn’t just the end of a relationship; it’s also the unraveling of a financial partnership," says Natalie Colley, partner and lead financial adviser at Francis Financial. "Untangling years of shared assets and responsibilities can feel overwhelming, especially when taxes are involved. Stocks, real estate, stock options and business interests each come with unique tax rules — and sometimes hidden liabilities. A single misstep can lead to the IRS knocking on your door after a sale, leaving you with a hefty tax bill."

Divorce and taxes

When couples divide assets during a divorce, taxes may not seem like an immediate concern. Thanks to IRS rules, most transfers between spouses aren’t taxed at the time of the divorce.

But here’s where it gets tricky: The value of the asset when it was originally purchased — called the cost basis — stays with it. This means that when the spouse receiving the asset decides to sell it down the road, they could face a large tax bill, especially if the asset has grown significantly in value.

To avoid these costly surprises, it’s essential to understand not only the value of all assets, but the basis, as well, during the divorce. With this information, you can make smarter decisions, ensuring the division of property is not just fair today, but also when you need to liquidate the account or sell the asset in the future.

Dividing assets equitably requires an understanding of their true value after taxes. While some assets come with minimal tax implications, others can trigger significant liabilities.

Cash

Cash transfers between divorcing spouses are straightforward. There are no taxes due on the transfers themselves, and when the money is taken out of the account to be used, there are no taxes then either. Note that cash left in a savings account earning interest will be taxable. You will receive a 1099-INT form each year that you will have to report on your tax return.

Real estate

Real estate, especially the family home, is often one of the most valuable assets in a divorce and the area that often causes the most conflict. Fortunately, the tax code offers a golden opportunity to save big when selling your home.

Couples who file jointly can exclude up to $500,000 of capital gains from taxes, while individual filers can exclude up to $250,000 — so long as the home was their primary residence for at least two of the past five years.

For couples who’ve already started living apart, meeting these requirements might seem tricky, but there’s good news: With the right planning, you can still qualify. If one spouse transfers ownership of the home to the other as part of the divorce, the receiving spouse can count the original owner’s time toward the two-year rule, possibly allowing them to shield up to $500,000 from capital gains taxes. Even better, if a divorce agreement allows one spouse to stay in the home temporarily until, say, the kids graduate from high school, the other spouse can also count that time toward their use requirement, allowing the $500,000 exemption to be used when the house is finally sold to a third party.

A well-thought-out separation agreement can ensure both parties keep their eligibility for this major tax break, even if only one spouse is living in the home. Planning is key.

Brokerage accounts

Brokerage accounts can be deceptively complex. Two accounts with the same balance may have vastly different tax consequences depending on how long the investments have been held, their cost basis and the investor’s income level. Gains on short-term holdings (assets held for less than one year) are taxed at higher ordinary income rates, while long-term holdings (assets held for more than one year) enjoy lower capital gains tax rates. Additionally, higher-earning spouses may face steeper taxes because of the net investment income tax (NIIT), potentially adding an additional 3.8% to their federal tax rate.

As mentioned earlier in the article, Georgia’s experience serves as a cautionary tale for divorcing spouses. She faced a nasty tax surprise when she liquidated her brokerage account to purchase a home, not fully understanding the tax implications of her decision.

Georgia’s story: In the divorce negotiations, Georgia agreed to take the $500,000 brokerage account they had started investing in when they first got married. Over the years, their investments grew handsomely, resulting in significant gains. However, the account’s cost basis is only $225,000, meaning it has $275,000 in long-term capital gains. While Georgia benefits from the lower 15% long-term capital gains tax rate, she faced a substantial tax bill of $41,250 when she eventually sold.

Georgia’s husband wanted the other $500,000 brokerage account, which had been invested in several high-risk stocks that he closely followed. Unfortunately, these investments didn’t perform well, leaving the account with a cost basis of $600,000. As a result, his account now reflects a $100,000 unrealized loss. If he sells these investments, he can use the $100,000 loss to offset other capital gains, saving tens of thousands of dollars in taxes. Alternatively, he can also apply up to $3,000 annually to reduce ordinary income, carrying forward the remaining losses until used toward future tax years.

What seemed like an equal division was, in reality, lopsided, due to the differing tax implications tied to the performance of each account. It’s a powerful reminder of why understanding cost basis and tax consequences is crucial when dividing assets.

Retirement accounts

Retirement accounts — such as 401(k)s, IRAs and pensions — are typically considered marital property if the funds were earned and contributed during the marriage. However, dividing these assets requires careful planning to ensure fairness and minimize tax consequences.

One of the most overlooked aspects of dividing retirement accounts is their tax treatment. Traditional 401(k)s and IRAs defer taxes until withdrawal, which means the account holder will owe income taxes on distributions during retirement. This can create significant tax bills, especially if the withdrawals push the account holder into a higher tax bracket.

In contrast, Roth 401(k)s and Roth IRAs are funded with after-tax dollars, and all qualified withdrawals — including earnings — are entirely tax-free. "Roth accounts are incredibly valuable because their tax-free withdrawals provide unmatched flexibility in retirement planning," says Colley, underscoring the importance of treating regular and Roth accounts differently in a divorce.

Georgia’s story: Georgia and her husband each took a retirement account valued at $350,000 during their financial planning and division of assets. Georgia chose her traditional 401(k) at work, believing it was equal in value to her husband’s 401(k). However, she later discovered that his account included a significant Roth component. Of the $350,000 in his account, $200,000 was in a Roth, meaning those funds would be tax-free upon withdrawal.

This difference dramatically affects the true spendable value of their accounts. Every dollar coming out of Georgia’s 401(k) will be taxed at her highest income tax rate. Assuming an estimated 30% rate, this $350,000 account will provide only about $245,000 in spendable income.

On the other hand, Georgia’s husband’s $350,000 account has a mix of tax treatments: The $200,000 Roth portion will not be taxed. Only the $150,000 traditional portion would be subject to ordinary income taxes. Based on her ex’s tax bracket, his account will provide a whopping $305,000 in spendable income — significantly more than hers.

Georgia’s story highlights the importance of fully understanding the tax implications of retirement accounts during a divorce. Even when account balances appear equal, Roth components can significantly impact the true value of assets.

Strategies to divide assets fairly

According to Colley, a Certified Divorce Financial Analyst who advises divorcing individuals at Francis Financial, “It’s almost impossible to divide everything perfectly equally in a divorce because different assets have different tax treatments. On top of that, each person usually has certain assets they care more about keeping.”

Colley shared that a good way to approach divorce asset division is to think of each asset with similar tax characteristics in “buckets” — grouping things like retirement accounts, investments and cash together — and then splitting those buckets as fairly as possible. Colley continues, “It’s a simple way to make the process more balanced for both sides.”

Who is the right professional to help?

Georgia’s experience highlights the critical importance of working with a professional who can anticipate and navigate the complexities of divorce and tax planning. Professionals like Certified Divorce Financial Analysts (CDFAs) or knowledgeable accountants bring invaluable expertise to the table, helping you proactively address potential tax traps and ensure informed financial decisions. Their guidance can mean the difference between a smooth financial transition and costly mistakes that could affect your future stability.

A CDFA specializes in the financial aspects of divorce, helping you understand the true value of assets by considering tax implications, future income potential and associated costs. For example, they can help you evaluate retirement accounts, real estate and investment portfolios, ensuring that each asset division decision aligns with your long-term goals. They also provide support in creating a financial plan tailored to your post-divorce life, focusing on areas like budgeting, retirement planning and tax efficiency.

Accountants experienced in divorce-related finances are equally vital, particularly when it comes to understanding tax liabilities and ensuring compliance with IRS rules.

By working with professionals who understand the nuances of divorce and taxation, you can avoid unpleasant surprises like Georgia’s unexpected tax bill. This proactive approach not only minimizes future tax bills but also sets the foundation for a more secure financial future. With the right team by your side, you can confidently move forward, knowing you are making the right decisions during divorce.

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