July 6, 2023
When you are considering how to divide a marital estate, it is important to look at the cost of many assets in addition to their current value. Cost may have an impact on what an asset is worth and could change its appeal or usefulness to your client. Let’s look at a few examples.
Mike and Joanne own a home worth $1 million. They purchased it 10 years ago for $400,000. They have agreed to sell it in the divorce and expect to have a gain of $550,000 (after paying 5% closing costs.) If they sell the house while jointly owned, they exceed the IRS threshold of $500,000 on the sale of a marital residence and would owe taxes on $50,000. The tax would be $7,500. However, if Joanne is awarded the house and takes Mike off the deed and then sells it, she is subject to the threshold for single taxpayers, which is only $250,000. Her taxable gain is $350,000 and she would owe the IRS $52,500. That’s an additional $45,000 in taxes!
While discussing the potential gain with Mike and Joanne, Mike mentions that they spent $80,000 on a new kitchen 3 years ago. This is considered a “capital improvement” and can be added to the cost basis, bringing it up to $480,000. Now if they sell the house while it is still jointly owned, that gain falls under the IRS threshold of $500,000 applied to the sale of a joint marital residence. They would not owe any taxes. However, if Joanne assumes the deed and sells it her taxable gain is $270,000, still above the threshold, but she would owe only $40,500.
Peter and Cathy have a joint annuity worth $100,000. Cathy would like this account so she can withdraw $1,000 per month to augment her income. Upon further inspection we see that the annuity has a cost basis of $50,000. That means half of each payment will be taxable as income, reducing Cathy’s net withdrawal to $850.
Charlene has an IRA that she started 15 years ago. Because she also contributed to a 401(k) for 5 of those years, some of her IRA contributions were “non-deductible.” That means they are considered like a ‘cost basis’ and are not taxable. When she takes money out of the IRA a portion of each withdrawal will be tax-free.
Other assets that have a cost basis include taxable investment accounts, stock options and employee stock purchase plans. The cost of these types of assets include not only what you paid for it, but might also include subsequent dividends or interest. It can get quite complicated but fortunately most investment custodians keep track of the total cost basis for the investor.