A divorce often brings to light a multitude of issues — from financial to legal to emotional. While it might not be on the top of your list during the transition, complying with the IRS on your next tax return means understanding how your carryforwards may be split when your joint return becomes two separate ones.
Carryforwards to examine may include capital loss carryforwards, charitable contribution carryforwards, suspended passive activity losses, S Corporation losses, investment interest expense carryforwards or net operating loss carryforwards. There are specific rules to follow for each — unless you and your spouse lived in a community property state at the time of the divorce (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin), which means it’s likely that any joint property acquired during the marriage would be divided equally upon a divorce.
Below outlines the typical types of carryforwards and how each will likely be treated on your next return.
When a joint couple had capital loss carryovers and the following year they file as separate individuals, each individual carries forward the amount of loss that arose from items they individually owned. If the properties generating the losses were jointly owned or treated as such in a community property state, the loss carryforwards would be split equally between the spouses.
A joint contribution carryforward is apportioned between spouses in the ratio of what their separate carryforwards would have been had they filed separately for the year in which the excess contribution arose.
However, if the spouses had originally filed separate returns, different tax rules would have applied so the result may not have equaled the total joint contribution carryforward the couple actually received. If this happens, the best way to allocate the charitable contribution carryforward from the joint return is to base it on the source of the income or property used to make the contribution that produced the carryforward. Again, community property states will most likely split the carryforward equally between spouses.
Suspended passive activity losses (PALs) do not carry over to the recipient. In the eyes of the IRS, since property a spouse receives due to a divorce is treated as a gift, suspended losses are added to the basis of the activity immediately before the transfer to the donee. Thus, the recipient’s deduction of the suspended passive loss is deferred until the property is sold.
Transfers or exchanges to a spouse or former spouse incident to a divorce are generally tax free. When a tax-free transfer of S Corporation stock occurs, the spouse who gets the stock also gets any carryover of disallowed losses or deductions.
The deduction for investment interest expense is limited for individuals by the amount of their investment income. If their investment expense is greater than their income, the excess is carried forward indefinitely. Since the computation for net investment income is different for regular and alternative minimum tax, individuals will most likely have different carryforwards between the two.
There is currently no administrative or judicial authority on how to allocate these carryforwards, leading to the presumption that any reasonable method could be used. In community property states, the reasonable method would likely be a 50/50 split.
NOL carryovers follow the individual who generated the NOL. If a joint return was filed that produced an NOL and the following year separate returns are filed due to divorce, the taxpayers must look back at the joint return to see whose losses generated the NOL. If the NOL was generated by each spouse, the carryover must be allocated between the spouses in the ratio of what the separate NOL carryforwards would have been if each spouse separately computed income and deductions. If taxpayers are in a community property state, the NOL again will most likely be split 50/50.
Available carryforwards can complicate your tax return after a divorce. And while the IRS has regulations to guide you through the division of these carryforwards, a best practice is to also document the required division in the divorce decree. This will help ensure the accuracy of each individual’s tax return going forward.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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