Dividing Tax Carryovers
Although often ignored, tax carryovers such as capital losses from investments, net operating losses from closely held businesses, passive activity losses from K-1 partnership statements, charitable contributions and Alternative Minimum Tax credits are all valuable assets that should be considered, awarded and offset in property divisions pursuant to divorce. These tax carryovers are considered to have inherent value, but not necessarily for either of the spouses. Some may be more valuable to one spouse over another and thus, the offset for the value needs to be considered for the non-recipient spouse.
Because of the potential tax implications that come with how carryovers are allocated, parties need to understand the different types of carryovers and how they are treated in order to properly appreciate an assign the potential impact equitably or equally depending upon the jurisdiction.
Tax carryovers that pertain to separate property that was acquired by one spouse prior to the marriage will be treated differently than those that are related to community or marital assets acquired during the marriage.
Capital loss carryovers
When an investment is sold at a loss, the capital loss incurred may offset any capital gains that are realized in the same tax year. However, in the absence of gains, only up to $3,000 may be used to offset ordinary income tax liability for interest, dividends and short term capital gains. The residual capital losses can be carried into the subsequent tax years and applied against gains or ordinary income until they are fully deducted.
In a divorce scenario, capital loss carryovers may be allocated against any separate property gains if they were incurred by those assets. The spouse who suffered the capital loss is able to use the carryover tax purposes. If losses were incurred on community property, the carryover can be divided equally or can be awarded to the spouse who may have better use of the tax loss given ultimate division of assets that are awarded to each spouse.
Net operating loss carryovers
With closely held businesses and Schedule C pass through entities, there may be allowable deductions for the investment or business that exceed the income generated. This results in a net operating loss and this loss may be carried forward to subsequent tax periods to reduce income tax liability on future revenue streams.
IRS regulations stipulate that net operating loss carryovers must be divided in the same manner that they would have been allocated if the divorcing parties had filed separate tax returns. This usually results in the business owner(s) being allocated the net operating loss carryovers proportional to their award of the business entity.
Passive-activity loss carryovers
Passive activities are those trades or business activities in which a party is not actively involved such as rental activities. The passive-activity losses are added to the tax basis of the assets in which they were incurred. If these assets are being transferred to another spouse as part of the division of assets, the losses are added to the tax basis of the assets being transferred.
The recipient spouse acquires the basis of the spouse who made the transfer. Losses generated from passive activities become part of the basis of the transferred property. Since the property transfers free of gift tax from one spouse to another pursuant to divorce, the basis of the transferred or gifted property is increased by the amount of the losses.
There should be calculated transferred interests if passive-activity loss carryovers are relevant in a divorce situation.
Charitable contributions carryovers
Similar to net operating loss carryovers, IRS regulations require that charitable contribution carryovers must be divided proportional to how the charitable contributions would have been divided if the couple had remained married and filed as married filing separately on tax returns.
Excess charitable contributions are non-negotiable and must follow the division prescribed by the U.S. Treasury regulations.
Alternative minimum tax credit carryovers
Again, these would be allocated in the same manner as if the parties filed separate returns. But because there are no prescribed IRS guidelines for AMT carryovers, the parties may divide these in a tax efficient manner that optimizes the tax credit or chose an allocation that meets the interests of the parties.
S Corporation Losses
When a tax-free transfer of S Corporation stock occurs pursuant to a buyout of one party’s interest in the business, the spouse who receives the stock also gets any carryover of disallowed losses or deductions.
Investment Interest Expense Carryovers
Any investment expense that is realized and greater than one’s income is characterized as excess loss and is carried over indefinitely. Net investment income is different than alternative minimum tax, but similarly to AMT carryovers, there is no IRS guideline regarding the allocation pursuant to divorce. Any reasonable method of allocation may be used. In California as a community property state this could mean the optimization of the tax loss by the party able to do so in the future or a simple equal division of the investment interest carryover.
Important decisions related to property division in divorce require the assessment and application of the governing regulations as well as the true value associated with the tax carryovers. Proformas as if the couple were to file as married filing separately may need to be prepared to prorate the losses between the spouses in accordance with these constraints. It is financially advantageous to consider these issues regarding tax carryovers well in advance of the final negotiations and preparation of the marital settlement agreement and certainly in advance of the filing of taxes pursuant to divorce.
Note: This article is for informational purposes only and is not intended to provide either tax or legal advice. Please contact your attorney or accountant and rely on their independent research and advice for these matters.
