What Is the Carryover Basis Rule in a Divorce?

Dividing property during a divorce involves tax considerations that can alter an asset’s true worth. A central principle is the carryover basis rule, which dictates how the tax cost of assets transferred between spouses is determined. Understanding this rule helps in achieving an equitable financial separation and avoiding future tax liabilities.

The Foundation of Carryover Basis in Divorce

Tax basis is the original cost of an asset, adjusted for items like improvements or depreciation, used to calculate the taxable gain or loss upon its sale. Under Internal Revenue Code (IRC) Section 1041, the transfer of property between spouses incident to a divorce is not a taxable event. This means no capital gains tax is due at the time of the transfer.

Instead of the asset’s basis being reset to its market value, the recipient spouse inherits the original owner’s tax basis. This is the carryover basis rule. The person receiving the asset steps into the shoes of the transferor, taking on their original purchase price and holding period, and the tax consequences are deferred until the asset is sold.

This rule applies to transfers within one year of the divorce or those “related to the cessation of the marriage,” which includes transfers made per a divorce agreement within six years of the final decree. The purpose of Section 1041 is to treat the divorcing couple as a single economic unit, preventing immediate taxation of asset shifts during a marital settlement.

Required Information to Establish Basis

To apply the carryover basis rule, the receiving spouse must obtain historical financial information from the transferring spouse. The responsibility for providing these records rests with the transferor, and this exchange should be mandated within the final divorce agreement to ensure compliance.

For real estate, the required information includes the original purchase price, the date of purchase, and records of any capital improvements. Capital improvements are costs that add to the property’s value or prolong its life, such as a new roof, and they increase the property’s adjusted basis.

For financial assets like stocks, the required documentation includes:

• The original purchase price and date for each lot of shares
• Records of any stock splits, which increase the number of shares without changing the total basis
• Records of any reinvested dividends, which increase the basis

Forgetting to account for reinvested dividends is a common error that results in overpaying capital gains tax.

Calculating Capital Gains on a Future Sale

The capital gain or loss on a future sale is determined by a formula: the asset’s sale price minus its adjusted carryover basis. For example, a spouse receives stock in a divorce that was originally purchased for $10,000 (the carryover basis). If the receiving spouse later sells the shares for $50,000, the taxable capital gain is $40,000 ($50,000 Sale Price – $10,000 Carryover Basis). The tax is owed by the receiving spouse, even though the appreciation occurred during the marriage.

A similar principle applies to the marital home. If a spouse receives the primary residence in the divorce and later sells it, they may be able to exclude a portion of the capital gain from income. Under IRC Section 121, a taxpayer can exclude up to $250,000 of gain ($500,000 for joint filers) if they meet ownership and use tests. The rule allows the receiving spouse to count the time the transferring spouse owned and lived in the home, helping them qualify for the exclusion.

For instance, if a home was bought for $300,000 (carryover basis) and the receiving spouse sells it for $600,000, the gain is $300,000. If the seller meets the requirements and files as single, they can exclude $250,000 of that gain, leaving only $50,000 subject to capital gains tax.

Reporting the Sale on Your Tax Return

After selling an asset received in a divorce, the transaction must be reported to the IRS. The forms for this are Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses.

On Form 8949, you report the details of the sale, including the proceeds, cost basis, and dates of acquisition and sale. For the “Date Acquired,” you must use the original purchase date of the asset by your former spouse, not the date it was transferred to you. This reflects the carryover of the original holding period.

The gain or loss from Form 8949 is transferred to Schedule D, which categorizes gains or losses as short-term (held one year or less) or long-term (held more than one year). The original holding period that carries over from the transferring spouse determines this classification. The net gain or loss from Schedule D is then carried to your main tax return, Form 1040.