Divorce and Taxes – A 4-Part Guide to Avoiding Costly Mistakes – Part 1: Hidden Tax Traps in Divorce: What You Need to Know Before Dividing Assets

By Vacca Family Law Group

When divorcing, it’s not just about who gets what—it’s about how those assets are taxed. Tax implications can dramatically alter your financial future, yet they’re often overlooked in the heat of negotiation.

In this 4-part blog series, we explore the critical but often-overlooked tax implications of divorce to help you avoid financial missteps and make better-informed decisions. For insights on this important topic, we asked two experts – Lili Vasileff, a Certified Divorce Financial Analyst (CDFA) at Wealth Protection Management, and Stacy Collins, a Certified Public Accountant (CPA) at Stout – to unpack these complex issues and offer real-world guidance.

Here’s what you can expect:

Whether you’re just starting to consider divorce or are already navigating the process, this series will equip you with critical tax knowledge to protect your financial future.

Tax Implications of Dividing Brokerage Accounts in Divorce

Stacy Collins points out that simply dividing brokerage accounts by their total value can be a mistake. It’s important to be aware of the unrealized capital gains within each account. If one account has a lot more gains than the other, one person ends up with a much bigger future tax bill. To divide fairly, you should look at each individual stock or investment and split those, not just the overall account value.

Long-Term vs. Short-Term Capital Gains: What Divorcing Couples Need to Know

Collins explains that if you sell an investment you have had for more than a year, it is a long-term capital gain, taxed at a lower rate (about 23.9% federally). If you sell it in less than a year, it is a short-term gain, taxed at your ordinary income rate (up to 37%). This is a huge difference, so it is important to pay attention to how long you have held investments.

Examples of the Varying Tax Implications of Different Asset Types in Divorce Settlements

Lili Vasileff points out that different asset types have varying tax implications, which can impact their true value during a divorce. Many people mistakenly look at the paper value of their different assets and assume they are valued the same. For instance, $500,000 in a brokerage account and $500,000 in home equity appear equal on paper, but their after-tax value can differ significantly due to potential capital gains taxes on the investments.

In divorce, the net after-tax value of an asset is its real value. Understanding how different types of assets are taxed is essential to accurately assess their worth. Here are some examples Vasileff highlights:

1. Cash – Cash is straightforward. Its value does not change, and there are no tax consequences when you divide or transfer cash in a divorce. Unlike other assets, cash does not create future tax liabilities.

2. Retirement Accounts – Vasileff explains that retirement accounts, such as 401(k)s, IRAs, and 403(b)s, have specific tax rules. These accounts are often tax-deferred, meaning you do not pay taxes until you withdraw the money. She cautions that if you take distributions before retirement age, you may face both income taxes and early withdrawal penalties. On the other hand, contributions to traditional retirement accounts may reduce your taxable income when you make them.

3. Investment Accounts – Assets held in brokerage accounts—like stocks, bonds, and mutual funds—are taxed based on how long you own them and how you earn income from them. For example:

  • Dividends may be taxed as ordinary income or at a lower qualified dividend rate.
  • Interest from bonds is taxed as ordinary income.
  • Capital gains are taxed when you sell the asset. Short-term gains (held for one year or less) are taxed at higher rates than long-term gains.

Vasileff also emphasizes that losses from these investments can offset gains, which can lower your tax liability. “Never overlook losses,” she advises, “because you never know when you may have a gain that you could marry up with the loss and minimize your tax impact.”

4. Real Estate – When it comes to real estate, Vasileff notes that the sale of a marital home may qualify for a tax exclusion. Each spouse can exclude up to $250,000 of profit from the sale, or $500,000 for a couple. She explains that if the property has been used for business purposes or rented out, the tax treatment changes. Depreciation taken on the property may need to be recaptured, leading to a larger tax bill for capital gains when you sell.

For more information, see Part 2: How to Minimize Capital Gains Taxes When Selling the Marital Home After Divorce

5. Business Interests – Vasileff highlights that ownership in a business can create unique tax issues. How the business is structured (e.g., sole proprietorship, partnership, S-corp, or C-corp) affects how the income is taxed. Additionally, the value of the business may fluctuate based on tax liabilities associated with future profits or losses.

For more information, see Divorce for Business Owners.

Reduce Taxes on Investment Assets in Divorce by Tracking Cost Basis

Your cost basis is what you paid for an investment. When you sell the investment, the difference between your cost basis and the sale price is your gain, and what you are taxed on. Collins emphasizes that “the higher the cost that you can document, the lower the potential gain.” If you don’t know your cost basis, you could end up paying more taxes than you should.

Why Tax Consequences Matter When Splitting Marital Assets

Tax consequences can significantly affect the value of assets divided in a divorce. Without careful planning, one spouse might end up with a much smaller share than intended. Working with financial and legal professionals who understand these issues can help ensure a more equitable and financially sound outcome.

At Vacca Family Law Group, we know how challenging this time can be. Our experienced team is here to provide the knowledge and support you need to make informed decisions. Contact us today for a free introductory call and learn how we can guide you through the divorce process with care and expertise.

Join us for Part 2 of this 4-part blog series, where we’ll discuss strategies to minimize taxes when selling the marital home.

More from this series:

Vacca Family Law Group is located at One Grand Central Place, 60 E. 42nd St., Suite 700, New York, NY 10165.

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