The Hidden Asset In Plain Sight
One of the greatest challenges for attorneys, mediators, and judges in family law property division cases lies in the first step of that process; identifying the assets to be divided. We seek verification of and evidence to determine if assets are community, separate, or co-mingled property. Some assets are evident and some are concealed despite the best efforts of those responsible for uncovering them. Still another group of assets hides in plain sight simply because practitioners may not be looking for them. Losses in investment portfolios will bring an especially obscure type of community asset into play in coming years like we have not seen in decades.
Largely due to the recession beginning in 2007, there has been a massive loss of American wealth over the past decade. An unfortunate reality of market psychology is many of the people who lost money over that period locked in their losses. Locking in those losses may have created a marital asset known as the capital loss carry-forward.
What is a Capital Loss Carry-Forward?
A capital loss carry-forward is a federal tax law that allows taxpayers to “carry forward” losses realized in one year to be used against income in later years. The rule exists because the IRS allows taxpayers to deduct capital losses only up to the level of their gains in any given year. The IRS does not believe this rule encourages investment in the growth of the American economy so it was decided taxpayers could spread the deductions over future years if necessary to recoup their realized losses. The reduction in future tax liability should be considered an asset for division to the extent the loss was incurred on a community asset.
Federal tax law states the reduction in future tax liability belongs to the person who realized the loss. From a titling perspective this means the capital loss carry-forward must follow title of the asset that created the loss. This rule does not always match with the goals of family courts. During a marriage the deduction would likely be taken on a joint tax return regardless of account title. In the years subsequent to divorce; losses related to an account held in the single name of a former spouse would escape the reach of the spouse not on title. There will be cases in the coming years where the value of these capital loss carry-forwards reaches six figures for high asset cases.
How Does This Apply To a Divorcing Couple?
Consider this example: An individual brokerage account titled in Husband’s name and funded entirely during marriage held $2,000,000 at the end of 2007. Between 2007 and March 2009 the account was invested entirely in the S&P 500 and realized capital losses of $1,140,000. The community had no other capital gains or losses in 2009 resulting in a capital loss carry-forward of $1,140,000. The couple was divorced on January 1st 2010. Over the next two years the stock markets rebound dramatically and both husband and wife, now divorced, realize capital gains in the amount of $500,000 each in 2011. Due to the fact the capital loss carry-forward follows title to the assets that create it, Husband would be entitled to the entire $1,140,000 of deductible losses to offset his gains resulting in $0 of taxes. Wife would have a federal income tax bill for $75,000 based on a generalized 15% effective federal tax bracket. Wife would need to realize $85,500 of federal income tax liability just to get back to where she started at the end of 2007. Based on the example the total estimated value of the capital loss carry-forward to the community was $171,000.
If the capital loss carry-forward is not treated as property in a divorce settlement it will be allocated under tax law according to title. This is likely not an equitable division. The capital loss carry-forward should be considered marital property when it arises from the sale of marital assets. Unfortunately, the family court lacks jurisdiction to change the title of the loss from one spouse to another. The only way to achieve an equitable division on this issue is to estimate the value of the tax benefit and award it to the titled spouse as part of the greater asset division. This would allow the non-titled spouse to receive an offset of other assets with similar value. Effective tax rates vary based on the specific circumstances of a taxpayer and are likely to change so the valuation should be performed by an experienced financial professional.