December 15, 2018
When assisting a couple with the division of assets, it is important to take into consideration each asset’s cost basis. This affects how items are taxed (if they are taxed) when sold. If there is significant tax to be assessed, then the real value of the item is much less that it appears on paper. And if your client is receiving an item that is truly worth half its current value once it is sold, that may have a profound effect on their future - the client could end up with much less money than it appears. Therefore, calculating the after-tax value of assets is important. Like a used car, you want to look under the hood before buying!
First, let’s define “cost basis.” Each item that the client owns or acquires through divorce has a cost associated with it. For some assets the cost is clear, such as a car – the cost is what you paid the dealer. The cost basis of a stock or mutual fund is the cost of purchasing each share. Other assets may have a more complicated cost basis (or “basis”) calculation. For instance, the basis of a home is the price that was paid to purchase it, plus the cost of any “capital improvements”, less any depreciation that has been taken.
In addition to knowing an item’s cost, you need to know how the IRS taxes that item. When an item is sold for less than its basis (which is common with cars) there is no tax owed. Items that are sold for more than their basis are sold at a gain, and generally subject to tax. This includes (but is not limited to) homes, investment real estate, stocks, bonds, mutual funds and collectibles. To take it one step further, taxable gains are either “short-term gains” (if held less than one year) or “long-term gains” (if held for one year or more.) Long-term gains have a more favorable tax rate than short-term gains. You can see that the process of figuring out the tax due on an item can quickly become complicated.
Retirement accounts, such as IRAs, Roth IRAs and 401(k)s, have different tax rules applied than those above. Most of these have taxes applied to every dollar that is taken out of the account, which are applied at the client’s ordinary tax rate (Roth IRAs, which are tax-free, are an exception to this rule.) Cost basis doesn’t matter.
Even if the item isn’t going to be sold now, we want to consider its after-tax value. As an example, Sally and Richard have decided that Richard will take the brokerage account and Sally will accept the IRA in their divorce (they are of equal value). The stocks in the brokerage account, if sold, would have capital gains taxed at 15% to Richard. Sally, because of her high income, would pay 24% tax on any IRA withdrawals. Her half of the assets would net less than Richard’s half.
Be wary of clients who cherry pick investments that they want to keep: John and Margaret agree to split their joint investment account, and each is going to sell some of the stocks in the account to pay off their respective credit card debt. John specifies that he wants the Pfizer and Disney stocks. He knows that these particular stocks were purchased years ago and have gains that will be taxed at 15%. The other stocks that Margaret will receive also have a gain but were bought within the past year and will incur tax at her ordinary rate of 22%.
The basis of a home is important to know if the home is going to be sold. If there is a gain the tax will depend on whether it is sold by the couple before the divorce or by one party afterwards, as well as how long it has been lived in.
Face value is one way to look at it, but cost basis gives you a more realistic look at the division of property.