Divorce traps: Portfolios harboring unrealized gains

By Tracy Stewart, CPA/PFS/CFF

A married couple are in the final stages of negotiating their divorce. The husband, who owns a network of used car dealerships, offers to split his personal investment account 50/50 with the wife. The wife is pleased with her share of the investment account. Looking at the market value of the investments at the time of the offer, all seems reasonable and fair.

What can possibly go wrong? Unbeknownst to the wife, the husband has picked investments with unrealized losses for his own portfolio and passed the ones with unrealized gains on to his soon-to-be ex-wife. The wife was not interested in the details of investments and did not make the time to consult with a tax specialist before signing the paperwork.

After the divorce is finalized, the wife reviews the portfolio allocations and decides that she is uncomfortable with the risk level of the investments she was awarded. In fact, the wife even hires a new investment adviser so she can have a fresh start that is free of anything the husband has ever touched. She asks her new investment adviser to sell those old investments and get her into a more conservative portfolio.

That is where the problem gets worse. In the reallocation, the wife converts unrealized gains into realized gains, which may be short-term (one year or less) or long-term (more than one year). She must now report those capital gains on her tax return. The additional taxes effectively lower the share of assets the wife received in the divorce settlement.

This highlights the importance of monitoring unrealized gains and losses, as well as understanding the tax consequences of dividing different types of accounts. If the couple aim for a 50/50 division of their savings and investment accounts, with the husband taking a $100,000 bank savings account while the wife gets a $100,000 investment account with $30,000 in unrealized gains, the spouses do not get a 50/50 division post-tax, no matter how good the deal may look on paper.

CPAs should consider the following key takeaways from this scenario:

  • When a client mentions that he or she is facing a divorce, offer to help him or her with tax issues. A CPA can add a lot of value by reviewing the property settlement agreement before it is executed.
  • A CPA should use the conversation as an opportunity to educate the client. When it comes to divorce, not all dollars are created equal. Asset types matter tremendously, and small details can skew a distribution that looks fair based on the numbers alone.

Even an amicable divorce can be extremely stressful, so the CPA cannot expect clients to remember to bring up questions. The CPA, as a trusted adviser, must be proactive in helping clients to spot these issues and prevent problems from developing.

For a detailed discussion of the issues in this area, see "Personal Financial Planning: Divorce and Taxes: Hidden Traps and Your Map Around Them," in the March 2018 issue of The Tax Adviser.

Tracy Stewart, CPA/PFS/CFF

The Tax Adviser is the AICPA's monthly journal of tax planning, trends, and techniques.

Also in the March issue:

  • An update on recent tax developments affecting individuals.
  • A look at transnational tax information reporting.
  • A discussion of the pitfalls of working indirectly with clients in the cannabis industry.

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