How the Tax-Free Transfer Rule Works when Divorcing

If you’re getting a divorce, you know it’s a highly stressful time. But if you own a business, tax issues can make things even more difficult. One of your largest personal assets is your ownership interest in a business, and in many situations, all or part of that interest will be included in your marital property.

Transferring property under the tax-free transfer rule

Generally speaking, there are no federal income tax or gift tax repercussions when you divide the majority of assets between you and your soon-to-be ex-spouse, including cash and business ownership interests. When an asset qualifies for this tax-free transfer rule, the spouse receiving the asset inherits both its current tax basis (for purposes of calculating a gain or loss on a tax basis) and its current holding duration (for purposes of determining a short- or long-term holding period).

Say, for example, that the terms of your divorce agreement require you to give your spouse your home in exchange for them keeping 100% of the stock in your company. Taxes wouldn’t apply to the asset transaction. Additionally, the stock and home’s current basis and holding period would be transferred to the recipient.

Tax-free transfers can take place either before or after a divorce is finalized tax-free. Post-divorce transactions are also exempt from taxes as long as they are made “incident to divorce.” This refers to transfers that take place within:

  • One year after the divorce date, or
  • Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.

Future tax implications

When a divorce settlement is finalized, assets received tax-free will eventually have tax ramifications. If the fair market value of the asset exceeds the tax basis, the ex-spouse who ends up owning it must typically report taxable gain when the item is sold (unless an exception applies).

What if your ex-spouse receives 49% of your highly appreciated small business stock? The tax-free transfer rule ensures that there is no tax consequence when shares are transferred. In terms of carryover basis and carryover holding time, your ex will continue to apply the same tax laws as if you had kept ownership of the shares. Your ex-spouse will be responsible for paying any capital gains taxes when they eventually sell the shares. You will owe nothing.

Note that the person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated. This is why you must always consider taxes when discussing your divorce settlement.

Additionally, instead of only applying to assets with capital gains, the beneficial tax-free transfer rule is now applicable to assets with ordinary income. For instance, you can transfer ordinary-income assets tax-free to your ex-spouse if you transfer business receivables or inventory to them during a divorce. The person who owns the asset at that time is responsible for recognizing the income and covering the tax liability if the asset is later sold, converted to cash, or exercised (in the case of nonqualified stock options).

Avoid adverse tax consequences

Like many major life events, divorce can have major tax implications. For example, you may receive an unexpected tax bill if you don’t carefully handle the splitting up of qualified retirement plan accounts (such as a 401(k) plan) and IRAs. And if you own a business, the stakes are higher. We can help you minimize the adverse tax consequences of settling your divorce.

© 2019. Updated August 2023.