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Who Gets The Tax Attributes In An Illinois Divorce?
For the wealthy, taxes are both a burden and a strategic opportunity in a divorce. Individual assets carry certain tax attributes that can be preserved, lost or traded away in an Illinois divorce.
If and you have an asset that will have an eventual tax liability should that asset be sold, traded, or trigger some taxable event, you need to know the consequences of a divorce on those assets and their tax attributes.
How Are Assets Divided In An Illinois Divorce
Anything either spouse owns or owes is labelled as “marital” or “non-marital” by an Illinois divorce court.
“‘[M]arital property’ means all property, including debts and other obligations, acquired by either spouse subsequent to the marriage” 750 ILCS 5/503(a)
“For purposes of distribution of property, all property acquired by either spouse after the marriage and before a judgment of dissolution of marriage or declaration of invalidity of marriage is presumed marital property.” 750 ILCS 5/503(b)
Non-marital property is…everything else. Usually, non-marital property is property acquired before the marriage and that remained in the owner spouse’s name exclusively.
“[T]he court shall assign each spouse’s non-marital property to that spouse.” 750 ILCS 5/503(d)
The remaining assets and liabilities will be marital and must be divided amongst the parties.
Illinois divorce courts “shall divide the marital property without regard to marital misconduct in just proportions considering all relevant factors [including]
the tax consequences of the property division upon the respective economic circumstances of the parties.” 750 ILCS 5/503(d)(12)
The marital assets will be divided by the court and the tax attributes related to those assets will also be divided and/or allocated equitably.
Tax Consequences of Property Division After A Divorce
The whole point of holding most assets that don’t have immediate utility like a car or jewelry, is to let them appreciate. Selling, transferring or gifting such as asset usually triggers a taxable event based on the appreciation of the asset.
The transfer of an asset pursuant to a divorce does not trigger a taxable event.
“No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)
a former spouse, but only if the transfer is incident to the divorce.” 26 U.S.C. Sec. 1041(a)(2)
Specifically, the gain or loss of any transfer is based on the sale price versus the basis.
“The basis of property shall be the cost of such property” 26 U.S.C. Sec. 1012(a)
“The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis” 26 U.S.C. Sec. 1001
Some tax events get spread out over years, however. If you have a tax event which is occurring both before the divorce and after the divorce, that event will have to considered, negotiated and then addressed in the Marital Settlement Agreement.
Capital Loss Carryforward And Divorce
Taxpayers can opt to use a capital loss carryforward to apply this year’s loss against next year’s gain.
“If a taxpayer other than a corporation has a net capital loss for any taxable year—
the excess of the net short-term capital loss over the net long-term capital gain for such year shall be a short-term capital loss in the succeeding taxable year, and
the excess of the net long-term capital loss over the net short-term capital gain for such year shall be a long-term capital loss in the succeeding taxable year.” 26 U.S.C. Sec. 1212(b)(1)
The right to declare this carry forward capital gains tax or loss must be agreed to by the parties or allocated by an Illinois divorce court. If the capital gain or loss was due to the sale or transfer of a non-marital property then the right to declare the carryover loss will be allocated to the original owner of that transferred non-marital property.
If the capital loss carry forward was due to the transfer of a marital property then that right to declare the loss can be divided between both parties or used exclusively by either party pursuant to agreement or by court order.
Charitable Contributions Carryovers And Divorce In Illinois
The Internal Revenue Code really likes it when people are charitable.
“There shall be allowed as a deduction any charitable contribution…payment of which is made within the taxable year.” 26 U.S.C. Sec. 170(a)(1)
If you give away more money than you make, you can carry over that deduction over the subsequent 5 years.
“In the case of an individual, if the amount of charitable contributions…of which is made within a taxable year…exceeds 50 percent of the taxpayer’s contribution base for such year, such excess shall be treated as a charitable contribution…paid in each of the 5 succeeding taxable years in order of time” 26 U.S.C. Sec. 170(d)(1)(A)
If the original charitable contribution came from a non-marital source, the owner of the non-marital funds can expect to retain the right to use the charitable contribution carryovers.
If the original charitable contribution came from marital funds, the parties to a divorce must divide these charitable contribution carryovers amongst themselves or ask the court to divide them equitably (it wouldn’t make sense to let someone with no tax liability keep any carryover deductions).
Net Operating Losses And Divorce In Illinois
General losses in past years back to 2017 can be used as a deduction against any income earned in the current year.
“There shall be allowed as a deduction for the taxable year an amount equal to…the aggregate amount of net operating losses arising in taxable years beginning after December 31, 2017, carried to such taxable year” 26 U.S.C. Sec. 176(a)(2)(B)
The right to declare these deductions were incurred during the marriage and are therefore marital property. This right to declare the past net operating losses in future years needs to be allocated between the parties by agreement or by court order.
Suspended Passive Activity Losses
Sometimes investments don’t work out right away. The first few years are a loss and the next few years are profitable. This is especially common with rental property as the property usually needs to be improved with no renter (loss) and then the property is rented with minimal ongoing expense (the profit).
The IRS codes allow taxpayers to smooth out these profits and losses over time. These losses are called “passive losses” and can be used later when there is an actual profit to be offset.
Passive losses that are not deductible right away are called suspended passive losses. These deductions are not lost forever. Rather, they are carried forward indefinitely until either of two things happen: 1) you have income you can deduct them against the loss, or 2) you dispose of your entire interest in the property.
When taking a suspended passive activity loss, the IRS looks at what the spouse is doing on their taxes as well.
“In determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer shall be taken into account.” 26 U.S.C. Sec. 469(h)(5)
The ability to take advantage of suspended passive activity losses is limited to tax payers where “more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements.” 26 U.S.C. Sec. 469(c)(7)(B)
So, someone in the family has to be working in the business or working on the property that is taking the suspended passive activity losses.
Typically, the transfer of a property prohibits future suspended passive activity losses.
“In general, if all gain or loss realized on such disposition…shall be treated as a loss which is not from a passive activity.” 26 U.S.C. Sec. 469(g)(1)(A)
But, suspended passive activity losses can be preserved if transferred to a spouse (whether pursuant to a divorce or not).
“If the taxpayer and the person acquiring the interest bear a relationship to each other [such as a spouse] then subparagraph (A) shall not apply” 26 U.S.C. Sec. 469(g)(1)(B)
Functionally, the transfer of a property with a passive activity interest to a spouse pursuant to a divorce decree creates a 26 U.S.C. Sec. 1041 transfer where the basis will be adjusted by adding the suspended losses to the basis.
If the transferor spouse wishes to recognize the suspended losses, themselves, they must sell the property to a third non-relative party.
So, these suspended losses must be accounted for when the parties reach a settlement or the court divides the marital property in “just proportions” 750 ILCS 5/503(d)
Consideration of tax attributes is not easy! Anyone who needs to go through the mental gymnastics of determining their property’s tax attributes is talking about a lot of money!
If you’re going through a divorce in Illinois and dividing tax attributes might be an issue for you, contact my Chicago, Illinois family law firm to schedule a free consultation with a Chicago divorce attorney.