Navigating Capital Gains Taxes in an Illinois Divorce

 Posted on October 31,2024 in Divorce

Dividing assets in a divorce can be a very complicated process, especially when capital gains taxes are involved. Capital gains taxes apply to the profit made from selling certain valuable assets, such as real estate, stocks, or high-value personal property, and these taxes can create unexpected costs for divorcing couples.

For high-net-worth couples in Elmhurst, Illinois, who have substantial assets, it is essential to understand how capital gains taxes could impact the division of property. Working with an experienced Illinois divorce attorney and a tax professional can help minimize capital gains tax liabilities while ensuring a fair division of assets and help a couple or individual preserve family wealth for future generations.

When Would a Divorcing Couple in Illinois Face Capital Gains Taxes?

A divorcing couple may face capital gains taxes when they sell assets that have appreciated in value during the marriage. Common examples include: 

• Primary residence: If a couple bought a home for $500,000 and it is now worth $800,000, selling it could yield a gain of $300,000.

• Investment properties: Selling rental properties that have gained value can trigger capital gains taxes.

• Stocks and bonds: Stocks purchased at a lower price and sold at a higher price may result in taxable capital gains.

• Mutual funds and other investments: Pooled investments that have increased in value and are liquidated could be subject to capital gains.

• Business assets: If the couple owns a business together, selling high-value equipment, real estate, or shares in the business could lead to capital gains tax liabilities.

• Valuable personal property: Collectibles like art, antiques, or vehicles that have appreciated may also incur capital gains taxes if sold.

Understanding which assets could lead to capital gains is crucial to making informed decisions during property division in a divorce.

How Can a Divorcing Couple Avoid Paying Capital Gains Taxes in Illinois?

There are several strategies a divorcing couple can use to reduce or even avoid capital gains taxes on certain assets. These include: 

• Utilizing the primary residence exclusion: If the couple has lived in their primary home for at least two of the last five years, each spouse may qualify for a capital gains exclusion on up to $250,000 of the gain. This exclusion can help minimize taxes on the home’s sale.

• Transferring assets instead of selling: Dividing assets by transferring ownership to one spouse, rather than selling them, can prevent immediate capital gains tax. If one spouse receives the marital home and the other spouse keeps other assets of equal value, capital gains taxes may be deferred until the assets are sold.

• Deferring taxes through installment sales: If one spouse is buying the other’s share of an asset (like a family business), arranging an installment sale may allow the spouse receiving payments to spread capital gains tax over several years.

• Timing the sale of assets: Waiting until the divorce is finalized and any asset transfers are complete before selling assets can be beneficial, as tax treatment of capital gains differs between jointly-owned and individually-owned assets.

• Setting up trusts: For high-value assets, placing them in a trust for children or beneficiaries could defer capital gains taxes until a later date or shift the tax burden.

Involving a tax professional in the divorce process can help ensure that these strategies are applied effectively and in compliance with federal and state tax laws. A tax professional can analyze each spouse's income and assets, assess potential tax liabilities, and work with the divorce attorney to create a plan that minimizes tax impacts, creating long-term benefits for both parties.

How Much Is Each Spouse Exempt from Capital Gains Taxes in Illinois?

Under federal tax laws, each spouse may be eligible for a significant capital gains tax exemption on the sale of their primary residence. Specifically, the IRS allows an exclusion of up to $250,000 in capital gains for single filers and $500,000 for married couples filing jointly, provided they meet certain criteria. In a divorce, this means each spouse could individually qualify for the $250,000 exemption if they have lived in the home for at least two out of the past five years.

However, if the home is sold jointly before the divorce, the $500,000 exemption for married couples applies. If only one spouse remains in the home post-divorce, that spouse may still qualify for the $250,000 exemption when they later decide to sell. Understanding these exemptions can significantly impact tax liabilities related to property division, making it essential to know each spouse’s eligibility.

How Does Personal Income Impact Capital Gains Taxes After Divorce?

After divorce, personal income levels can play a key role in determining the rate at which capital gains are taxed. In the United States, capital gains taxes on assets held for over one year (long-term capital gains) are determined by federal income tax brackets. Generally, people in lower income brackets (up to $44,625 for single filers in 2023) may qualify for a 0% capital gains tax rate.

However, for higher income levels, capital gains rates can increase to 15% or even 20%. For example, if a high-net-worth spouse earns income above $492,300 as a single filer, any capital gains will be taxed at the maximum 20% rate.

Since post-divorce income often includes maintenance (alimony), earnings from a new job, or income from investments, it is important to consider how these sources may push each spouse into a higher tax bracket, increasing their capital gains tax liability. By working with a financial professional, divorcing spouses can gain a clear understanding of how their adjusted incomes could impact capital gains taxes on future asset sales.

Is Spousal Support and Child Support Included in Income for Capital Gains Tax Purposes?

Spousal support (alimony) and child support are treated differently for tax purposes, and this can impact capital gains tax calculations after divorce. Under current tax law, spousal support is considered taxable income for the recipient, meaning it could increase their total income and potentially affect the rate at which capital gains are taxed. For example, if a person receives significant spousal support payments, these funds will be added to their adjusted gross income (AGI), possibly pushing them into a higher tax bracket and increasing the capital gains tax rate on any asset sales.

In contrast, child support is not counted as taxable income for the recipient, nor is it deductible by the paying spouse. Because child support payments do not contribute to taxable income, they do not affect capital gains tax rates. However, when negotiating divorce terms, understanding the tax implications of both spousal and child support can be essential for effective financial planning, especially for high-net-worth individuals facing asset division and potential capital gains.

What Is the Difference Between Short-Term and Long-Term Capital Gains in Divorce?

When dividing assets during a divorce, it is crucial to distinguish between short-term and long-term capital gains, as they are taxed at different rates. Short-term capital gains apply to assets held for one year or less, and they are taxed at ordinary income tax rates, which can be significantly higher—up to 37% for high-income earners. On the other hand, long-term capital gains apply to assets held for more than one year and are typically taxed at preferential rates of 0%, 15%, or 20%, depending on the taxpayer's income.

For divorcing couples with substantial assets, selling certain high-value properties or investments could create a large taxable gain. By prioritizing long-term assets for division or sale, a couple may reduce the tax burden compared to short-term assets. This approach allows each spouse to benefit from the lower long-term capital gains rates, which can be a key tax planning strategy during divorce negotiations.

Can Putting Assets Into a Trust for Children Help Avoid Capital Gains Taxes in Divorce?

Transferring assets into a trust for children can be an effective strategy to reduce capital gains taxes in a divorce. This approach not only benefits the children but can also provide both spouses with substantial tax savings by deferring capital gains until the assets are sold.

When assets are placed in a trust, the trust becomes the owner, and the parents are no longer directly liable for capital gains taxes on any future appreciation. Additionally, since the transfer removes the assets from the parents' taxable estate, using a trust may also help in estate planning by reducing estate taxes.

For divorcing parents considering this option, some commonly transferred property types include: 

• Real estate holdings: Primary residences, rental properties, vacation homes, or commercial real estate.

• Investment portfolios: Stocks, bonds, mutual funds, and other appreciated securities.

• Business interests: Family businesses, LLC memberships, or shares in a corporation.

• Valuable personal assets: High-value art, antiques, jewelry, and collectibles.

• Life insurance policies: Policies that may be transferred into an irrevocable life insurance trust.

There are various types of trusts that may be suitable for divorcing parents, each offering different levels of control, tax benefits, and flexibility. Common options include: 

• Irrevocable Trusts: Once established, these trusts cannot be changed or revoked, making them a popular choice for asset protection and tax advantages.

• Revocable Trusts: These trusts allow parents to maintain control over the assets and make changes if needed, though they may offer fewer tax advantages compared to irrevocable trusts.

• Generation-Skipping Trusts: Designed to benefit grandchildren and future generations, these trusts help to minimize estate taxes by bypassing the children’s generation.

• Charitable Remainder Trusts: With this type of trust, assets can eventually go to a charity, which allows parents to receive an income stream while potentially deferring capital gains and providing a charitable tax deduction.

• Life Insurance Trusts: Holding a life insurance policy in a trust can protect the policy’s value from estate taxes, ensuring more goes directly to the children or other beneficiaries.

Using a trust requires careful planning to ensure compliance with tax laws and the terms of a divorce agreement, so it is advisable to consult a tax professional and a divorce attorney to select the best trust structure that meets both tax and family goals.

Can Divorcing Parents Gift Assets to Their Children to Avoid Capital Gains Taxes?

Gifting assets to children during a divorce can be another way to reduce capital gains taxes, but it is essential to understand how this strategy works under tax laws. When parents gift appreciated assets directly to their children, the children inherit the original purchase price, or "cost basis," of the asset. This means that if the children sell the asset later, they may owe capital gains taxes based on the increase in value from the original cost basis to the selling price.

However, gifting can be an effective way to lower estate taxes, as the annual gift tax exclusion allows each parent to give up to $17,000 per child (as of 2023) without incurring gift taxes. In some cases, parents may gift assets that are unlikely to be sold soon, such as stock in a family business, to defer capital gains. Still, it is important to consider both immediate tax implications and long-term financial plans.

Consulting with a tax professional and a divorce attorney can help parents understand the advantages and limitations of gifting assets to children and determine if this approach aligns with their financial goals in the divorce process.

Contact a DuPage County, IL Divorce Attorney to Manage Capital Gains Taxes in Divorce

If you are a high-net-worth individual getting divorced, the potential for paying major capital gains taxes requires careful attention and planning. When it comes to choosing the right strategies to reduce taxes, having personalized guidance ensures you are protected financially. Contact an Elmhurst, IL high net worth divorce attorney who can work with you and a tax professional to create a strategy tailored to your financial needs.

At Weiss-Kunz & Oliver, LLC, we run a boutique law firm with personalized attention to every client, so you can go through divorce knowing for sure that your interests are represented. Call 312-605-4041 to discuss your unique case and learn how our firm can help you with property division, capital gains concerns, and other financial aspects of your divorce.