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Tax Carryovers in High Asset Divorce


Often overlooked in the divorce context are tax carryovers. Tax carryovers are generally considered to be community assets to the extent that such carryovers were acquired during the marriage. Tax carryovers include such things as capital loss carryovers, charitable contribution carryovers, and passive loss carryovers. These items are often not taken into consideration in the divorce proceedings although they should be. The reason for this is that they are simply not on anyone's radar and are thus missed completely or alternatively the complications in valuation simply make it easier for practitioners and the court to overlook these items, despite their community property nature.

It is important to understand what these carryovers are. A capital loss occurs when an asset is disposed of for a price lower than which it was acquired for. The net loss is a capital loss. The IRS allows for these capital losses to be tax deductible up to the amount of $3,000 per year. This means that if you take a loss up to or more than $3,000 on a capital expenditure, after disposition, you can take a deduction from your taxable income in an amount up to the amount of the loss not to exceed $3,000. In the event that this capital loss exceeds $3,000 then the IRS allows taxpayers to carry over this deduction into future years. Thus the taxpayer doesn't lose the benefit of the deduction and can realize the benefit over the course of time.

It is also important to know the distinction between short term and long term capital losses and gains for purposes of valuing this carryover interest. Capital gains made on assets held for less than one year are considered short term capital gains. Capital losses on property held less than one year is a short term capital loss. Capital gains on property held for more than one year are long term capital gains and capital losses held on property held for more than one year and long term capital losses. The distinction is important as short term capital gains are typically taxed at a higher rate than long term capital gains. Short term capital losses can be used to offset short term capital gains. Given this fact short term capital losses are generally more valuable the long term capital losses.

The question becomes what happens if a married couple takes a capital loss during the marriage and then later divorces and still has a capital loss carryover on the books available as a deduction for future years? In years following the divorce they will now be filing separate returns as opposed to joint returns. Several state Supreme Courts have held that this deduction, being earned during the marriage, constitutes a community asset. The question then becomes how is this asset to be divided? In Nevada, our community property laws say that all assets, minus a couple of exceptions, are to be divided equally unless there is a compelling reason to do otherwise. However, this is in direct conflict to IRS regulations. Treasury regulations require the carryover to be allocated to the husband and wife on the basis of their individual net capital losses for the preceding year. This thus requires one to allocate capital losses for each of the two spouses and then to allocate within each spousal share the division of short term vs long term capital carryover. It seems that state laws thus contravene treasury regulations in this regard.

An Expert will typically be needed to conduct valuation here. The expert first must determine what rate to use by looking to see if the loss will be used to reduce a long term or short term capital gain. The expert will then need to conduct a present value analysis to determine what the present value of this future tax deduction will be. This will depend on variables which are not necessarily easily determinable. Additionally, the expert will have to determine in which year or years to apply the carryover to.

Keep in mind that the entire amount of the future deduction is not likely to be considered "community property". What should be considered community property is the amount in which current or future taxes will be reduced because of this deduction. The amount of the reduction is the community property element, not the carryover deduction itself.

Another deduction to keep an eye out for is that of the charitable deduction. Contributions to charitable organizations are deductible up to 50% of the donor's income in a given year. What this means is that if a donor makes a sizable donation, exceeding 50% of his current year's income, then this amount that exceeds 50% can be carried forward and used as a deduction in future years. The charitable contribution carryover differs from capital loss carryover in that this deduction needs be deducted over the five following years or until it is fully utilized, whichever occurs first. The issue again arises when the contribution is made in a year of marriage and the parties then divorce thus filing separate returns the following years. The IRS regulations again require that distribution be in accordance with how much of this amount would be attributable to each spouse assuming that they had filed separately in the divorcing year when they in fact likely filed jointly. This again is in contradiction to State Supreme Court law which orders the equal or equitable division despite the IRS regulations stating otherwise.

Valuing charitable contribution carryovers is decisively easier than valuing capital loss carryovers given the certainty of the losses being applied in the immediate five years or until otherwise utilized, whichever occurs first. Your expert can often times come up with a present value estimation by looking at the prior consistent patterns of table income for the purpose of projecting future taxable income. Again, the value of the carryover is the tax savings which occurs when the deduction is subtracted from gross income.

The final area where you are likely to see these carryovers is in the circumstance of the passive loss. Losses which occur on passive activities are considered to be passive losses. Passive activities include trade or business activities in which the taxpayer does not materially participate. The IRS regulations require that these passive losses not be used as deductions in the year in which they are acquired for the purposes of reducing other income such as wages, interest, and dividends. These passive losses can however be used to reduce other passive income. Passive losses which cannot be applied to ordinary income are carried forward to future years. Thus in the divorce case the value of these passive losses is the present value of a future realizable tax benefits. In the event that these losses cannot be used currently then the expert must project as to what the anticipated tax benefit will be upon dissolution of the passive income asset.

Thus, as counsel you should be looking out for these potential carryovers. Seek this information in the discovery process. Remember that if you don't seek to obtain your client's community interest in that asset that he or she will likely never see the benefit of that asset unless he or she is the owner of the entity accruing the carryover in which case IRS regulations will bestow the benefit upon that individual client anyway.

Categories: Family Law