Capital Gains Tax in Colorado Dissolution of Marriage Proceedings

Are you involved in a Colorado divorce or family law proceeding involving divorce or capital gains tax? An experienced Colorado Springs divorce attorney can guide you through the capital gains tax process and assist you in exploring your options. You have one bite at the apple in the court system so make it count.

Colorado domestic relations courts have broad authority to divide marital property and allocate tax liabilities between spouses, however the federal tax treatment of property transfers incident to divorce is governed primarily by Internal Revenue Code Section 1041. This applies to dissolution proceedings in which spouses transfer certain property that has increased in value as part of a property settlement. In this event, one or both spouses may face capital gains tax liability either from interspousal transfers or from subsequent sales of marital assets to third parties.

Federal tax law governs gain or loss on property transfers incident to divorce. However there are protections for transfers incident to divorce. Under 26 U.S.C. § 1041(a), no gain or loss is recognized on a transfer of property from an individual to a spouse or to a former spouse if the transfer is incident to the divorce. A transfer is incident to divorce if it occurs within one year after the date on which the marriage ends. Property received in such a transfer is treated as acquired by the transferee by gift and is excluded from the recipient's gross income. The recipient takes a carryover basis in the property equal to the transferor's adjusted basis at the time of receipt. Section 1041 applies only to transfers of property between spouses or former spouses incident to divorce proceedings. Once an interspousal transfer subject to Section 1041 is complete, Section 1041 no longer applies, and later transfers to third parties are not covered.

Capital gains tax liability may arise in several situations during and after dissolution proceedings:

Post-Transfer Sale to Third Parties. The most frequent trigger occurs when the recipient spouse later sells appreciated property to a third party. If the recipient later transfers the property to a third party, the gain or loss must be recognized based on the carryover basis received under Section 1041. The recipient takes the transferor's basis in that property, not a stepped-up basis equal to fair market value. For example, if Husband transfers stock with a $50,000 basis and a $200,000 fair market value to Wife pursuant to a dissolution decree, Wife receives the stock tax-free but inherits Husband's $50,000 basis. When Wife later sells the stock to a third party for $200,000, she will recognize $150,000 of capital gain. Although the interspousal transfer itself is not a taxable event under federal law, the embedded capital gains tax liability travels with the property and will eventually be realized by the spouse who receives the asset and later sells it.

Sale of Real Property to Fund Settlement. Capital gains tax may become due when the marital residence or investment real estate is sold to a third party as part of the property settlement, either before the decree or shortly thereafter. If both spouses have lived in the home as their principal residence for at least two of the five years preceding the sale, each may exclude up to $250,000 of gain under 26 U.S.C. § 121. If the property has appreciated beyond those thresholds or does not qualify as a principal residence, the gain or excess gain is taxable.

Liquidation of Retirement Accounts. Early withdrawal from qualified retirement accounts can trigger both ordinary income tax and capital gains tax on appreciation within the account, depending on the account type and the nature of the assets held. Transfers pursuant to a Qualified Domestic Relations Order (QDRO) avoid the 10% early withdrawal penalty. However, if a spouse takes early distributions, those may be taxable.

Law firm practice observation – it is always important to include provisions for how capital gains will be allocated in a separation agreement. This is particularly the case when the sale of an asset, such as a home, is anticipated and imminent.

A property settlement incident to a divorce is not a taxable event and does not give rise to gain or loss. The court may apportion tax liabilities assessed on the parties' joint return in proportion to each party's earned income for the relevant tax year, allocate the gains to one party or the other, or divide the liability equally. However, the state court orders do not bind the federal government, nevertheless they do govern rights and obligations between spouses. If the tax is not paid, the federal government will pursue both parties for payment regardless of what the state court order requires. In a dissolution, Marital tax debt for all years prior to the dissolution should be divided equitably.

Turning Change Into Opportunity in Colorado Springs Divorce and Child Custody

A highly knowledgeable and experienced Colorado Springs divorce attorney can guide you through Colorado Springs divorce and capital gains matters by negotiating, mediating and litigating on your behalf. You can focus on moving to a better future instead of spending your time attempting to navigate complex legal rules and procedures.

Sabra Janko from Janko Family Law has more than 20 years of legal experience and has written “the book” on Colorado divorce and family law – “Colorado Family Law With Forms”, published by LexisNexis, which you can find at here. Contact us at 719-344-5523 or complete our online scheduling request for a free 30-minute informational consultation. We also offer paid advice sessions for a more in-depth analysis of your case.