Capital Gains Tax and Divorce: What You Need to Know

Divorce can have significant financial consequences, especially regarding taxes. Capital gains tax applies when assets are sold for a profit, and the way property and investments are divided can determine when and how much tax will be owed. Understanding how different assets are taxed and what exemptions or deferrals apply can help minimize liabilities.

Real Estate Transfers

When real estate is transferred between spouses as part of a divorce, it is generally not subject to immediate capital gains tax. Under Section 1041 of the Internal Revenue Code, these transfers are treated as gifts, meaning no gain or loss is recognized. The receiving spouse assumes the original cost basis and holding period, which affects future tax liability when the property is sold.

If the property is sold after the divorce, capital gains tax may apply depending on the sale price and adjusted cost basis. The IRS allows a primary residence exclusion under Section 121, letting individuals exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) if they meet ownership and use requirements. To qualify, the seller must have owned and lived in the home for at least two of the last five years. If one spouse keeps the home and later sells it, they can only claim the $250,000 exclusion unless they remarry and file jointly.

Selling the home before finalizing the divorce can simplify tax consequences. A sale while still married and filing jointly may qualify for the full $500,000 exclusion, reducing or eliminating taxable gains. If the sale happens after the divorce, each spouse is responsible for their share of any taxable gain based on their ownership percentage.

If one spouse keeps the home and the other retains partial ownership, tax implications become more complex. If the departing spouse later sells their share, they may owe capital gains tax on appreciation. Structuring the transfer as part of the divorce settlement rather than a later sale can help avoid unexpected tax liabilities.

Investment Portfolios

Dividing investment portfolios introduces tax considerations, particularly regarding capital gains. While real estate transfers between spouses are generally tax-free, selling stocks, bonds, or mutual funds to split assets may trigger taxable events. The impact depends on the cost basis, holding period, and market value at the time of sale or transfer.

When investments are liquidated as part of the divorce, any gains realized from the sale are subject to capital gains tax. The rate depends on how long the asset was held. Securities owned for more than a year qualify for long-term capital gains tax rates, which in 2024 range from 0% to 20%, depending on taxable income. Short-term holdings are taxed as ordinary income, which can be significantly higher.

If investment accounts are divided without selling assets, the receiving spouse assumes the original cost basis and holding period. When they eventually sell, they owe capital gains tax based on the difference between the sale price and the original purchase price. This is particularly important for highly appreciated stocks, as the tax liability may be substantial. Proper documentation of the cost basis is necessary to avoid IRS disputes.

For jointly owned brokerage accounts, deciding how to split individual holdings can be challenging. Some couples divide investments proportionally, while others negotiate transfers based on growth potential or tax implications. If one spouse receives high-growth stocks while the other takes cash or lower-growth assets, the long-term financial impact can be uneven. Consulting a financial advisor can help ensure an equitable distribution that considers both immediate and future tax consequences.

Retirement Assets

Dividing retirement accounts requires careful planning to avoid unnecessary taxes and penalties. The type of account—Traditional IRA, Roth IRA, or employer-sponsored plan—determines tax treatment for withdrawals and transfers. Properly structuring the division can prevent unexpected tax liabilities and ensure compliance with IRS regulations.

Traditional IRA

When a Traditional IRA is divided in a divorce, tax-free transfers are allowed if done under a Qualified Domestic Relations Order (QDRO) or a divorce decree. The receiving spouse takes ownership of the transferred portion and assumes responsibility for future tax obligations. If the funds are withdrawn instead of transferred, they are subject to ordinary income tax and may incur a 10% early withdrawal penalty if the account holder is under 59½.

For example, withdrawing $100,000 from a Traditional IRA in the 24% tax bracket results in a $24,000 federal tax bill. If under 59½, an additional $10,000 penalty applies, bringing the total liability to $34,000. To avoid this, funds should be transferred directly into the receiving spouse’s IRA. Proper documentation, including a court-approved divorce decree, is necessary to ensure the transfer is tax-free.

Roth IRA

Roth IRAs follow similar transfer rules but have different tax implications. Since contributions are made with after-tax dollars, qualified withdrawals—including earnings—are tax-free. The receiving spouse takes ownership of the transferred portion and maintains the original contribution and conversion history.

For instance, if a spouse receives $50,000 from a Roth IRA originally funded more than five years ago, they can withdraw contributions tax-free at any time. However, withdrawing earnings before meeting the five-year rule may result in income tax and a 10% penalty unless an exception applies. Keeping detailed records of contributions and conversions is essential to avoid unexpected tax consequences.

Employer-Sponsored Plans

Dividing 401(k)s, 403(b)s, and other employer-sponsored retirement plans requires a QDRO to ensure tax-free transfers. Without a QDRO, any distribution to a spouse is treated as a taxable withdrawal, potentially triggering income tax and early withdrawal penalties. The QDRO directs the plan administrator to transfer a specified portion of the account to the receiving spouse, who can then roll it into their own retirement account without immediate tax consequences.

If the receiving spouse takes a cash distribution instead of rolling the funds into another retirement account, they will owe income tax. However, unlike IRA withdrawals, the 10% early withdrawal penalty does not apply if the distribution is made under a QDRO, even if the recipient is under 59½. For example, if a spouse receives $75,000 from a 401(k) and is in the 22% tax bracket, they would owe $16,500 in federal taxes but avoid the $7,500 early withdrawal penalty. Understanding these rules can help divorcing spouses decide whether to take a lump sum or preserve retirement savings.

Filing Status Changes

The tax implications of divorce extend beyond asset division, with filing status being one of the most immediate changes. The IRS determines filing status based on marital status as of December 31. If a divorce is finalized by this date, individuals must file as single or, if they qualify, as head of household. If still legally married, filing jointly or separately remains an option, each with distinct tax consequences.

Head of household status can provide tax benefits, including a higher standard deduction ($21,900 in 2024 vs. $13,850 for single filers) and more favorable tax brackets. To qualify, the filer must have a dependent, such as a child, and pay more than half the household expenses. Claiming this status requires careful documentation of residency and financial support, as the IRS may scrutinize eligibility.

Filing separately while still married is often less advantageous due to the loss of certain deductions and credits, such as the Earned Income Tax Credit and education credits. However, it may be beneficial if one spouse has significant medical expenses or unreimbursed business costs that exceed deduction thresholds based on adjusted gross income.

Documenting Capital Gains

Tracking capital gains is essential during and after a divorce. Since capital gains tax is based on the difference between an asset’s sale price and its cost basis, maintaining accurate records of original purchase prices, improvements, and prior depreciation is necessary to determine taxable amounts.

For real estate, records should include the original purchase price, closing costs, and receipts for any capital improvements, which can increase the cost basis and reduce taxable gains. Investment accounts require transaction histories showing purchase dates and prices, as well as any reinvested dividends or stock splits that affect basis calculations. Keeping these records organized ensures compliance with IRS requirements and minimizes the risk of overpaying taxes when assets are eventually sold.