Divorce & Investment Portfolios
For high-net-worth couples, dividing investments in a divorce is rarely straightforward. With portfolios that include everything from real estate to retirement accounts, each asset comes with its own tax implications, risks, and liquidity concerns. In California, understanding how community property laws apply—and working with the right legal and financial team—can make all the difference in preserving your wealth and reaching a fair settlement.
Divorce & Investment Portfolios
For high-net-worth couples, dividing investments in a divorce is rarely straightforward. With portfolios that include everything from real estate to retirement accounts, each asset comes with its own tax implications, risks, and liquidity concerns. In California, understanding how community property laws apply—and working with the right legal and financial team—can make all the difference in preserving your wealth and reaching a fair settlement.
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When a high-net-worth couple decides to end their marriage, dividing up the investments that they have accumulated together while married is invariably a complex process. The larger their shared estate, the more likely it contain a wide variety of different types of assets, including stocks, bonds, real estate, businesses, retirement plans like 401(k)s or IRAs (individual retirement accounts), and more. Unlike a savings account that can be neatly split down the middle to give each spouse an equal share, these varied types of investments carry different tax implications for future sales, levels of risk, potential for future growth, income generation, and liquidity, all of which need to be considered in achieving a property division settlement that is fair to both parties.
California, which is a community property state, considers anything spouses earn during marriage and the property purchased with that income as belonging to both equally. Even when separate property is excluded from division (assets that either party owned before the marriage, as well as gifts and inheritances, as long as they were not commingled with marital property or subject to the terms of a prenuptial or postnuptial agreement), marital property can include the majority of a couple’s assets, however, this does not mean that divorcing spouses are required to take an identical share of each of these assets; such a plan may not be to either’s advantage, even if it were possible. Instead, negotiating an equitable property division settlement with the guidance of legal, financial, and tax professionals can help create a plan that is mutually beneficial and preserves the value of their portfolio.
Issues to Consider in Divorce and Investment Portfolio Division
One of the most fundamental issues in dividing a complex investment portfolio, and potentially one of the more difficult to figure out, is determining each asset’s true worth. Depending on the type of asset under consideration, the factors to be considered can include its current fair market value, tax consequences if it is sold, its potential for growth, its cost basis, its income-generating capacity (if any), and more. When a couple’s portfolio includes assets such as investment real estate or closely held businesses, obtaining a professional business valuation and/or real estate appraisal is strongly recommended. Getting a full and accurate picture of the assets to be divided is essential to provide a mutually shared understanding on which to base negotiations.
Another important factor to consider is each party’s differing priorities and financial goals. For example, one spouse may wish to retain control of the family business, while the other wants to hold onto rental properties to maintain ongoing income. When market conditions are down, neither may wish to sell assets at a loss; alternatively, a higher-earning spouse may be open to taking depreciated stocks to harvest a tax loss. The input of both financial and tax experts can be invaluable in helping to create a balanced settlement that protects both parties’ financial futures.
Tax Implications of Dividing Investments in Divorce
Federal law considers transfers of property to a former spouse incident to a divorce to be tax-free transfers. No gain or loss is recognized, and the spouse receiving the asset inherits its original cost basis. While no tax is therefore due at the time of the divorce, if the asset is later sold, the spouse who owns it will be responsible for paying any capital gains tax owed.
Retirement accounts can generally be similarly divided without immediate tax consequences. For IRAs, an account can be divided as a transfer incident to divorce without it being taxable, although the recipient spouse may owe taxes if they choose to take a portion of the value as a distribution rather than rolling it into another retirement account. Retirement plans covered by the Employment Retirement Income Security Act (ERISA), such as 401(k)s and 403(b)s, require a qualified domestic relations order (QDRO) to be split as a tax-free event. It is best to work with experienced legal and financial professionals to ensure these transfers are completed and recorded correctly; otherwise, they may be deemed subject to income tax as ordinary income by the IRS and potentially incur early withdrawal penalties.
Avoiding taxation on the sale of investment real estate can be more difficult to achieve. A common strategy investors use to avoid paying capital gains tax on the sale of an investment property is to perform a 1031 exchange to purchase a like-kind property. Unfortunately, this method requires that the same owner(s) sell and buy the affected properties; it would not, for example, enable a divorcing couple to sell a single jointly owned investment property and purchase two separate ones. However, if one spouse receives a property outright in the property division settlement, they may elect to do a 1031 exchange later to buy a new investment property that may be better suited to their financial goals and circumstances and defer capital gains taxes.
The specific tax implications a couple might face in dividing their property in a divorce will depend on their individual circumstances and holdings. Consulting with the appropriate legal, financial, and tax experts is essential for understanding the potential implications of all their options, whether they choose to sell assets immediately, divide them, or retain joint ownership for the time being.
Divorce, Inheritance, and Estate Planning
Working through the financial issues of a high-net-worth divorce can extend the timeline until it is finalized, even if the process is relatively cooperative. This increases the risk that an unforeseen accident or illness could result in unintended consequences for a spouse’s estate if the way they hold their property and/or their estate plan has not been updated.
If property is held in joint tenancy, a legal arrangement in which two or more individuals share property ownership with equal rights and obligations to that property, a surviving tenant (co-owner) has the right of survivorship after the other’s death. They inherit that person’s share of the property automatically, overriding any will or other estate planning that might designate another heir. Therefore, couples in the midst of a divorce should sever joint tenancy in any affected properties (most often real estate, though it may apply to investment or brokerage accounts) to convert it to a tenancy in common, which preserves the right of each to gift their share to the beneficiaries of their choice. An experienced estate planning attorney can ensure this is done properly according to California law. Any property they choose to retain joint ownership on after divorce should also be held as tenants in common.
Each party should also review previous estate planning and revise their will and/or living trust. It is not necessary (or advisable) to wait until the divorce is finalized to begin this process; while California Family Code § 2040 places restrictions on what spouses can do with their shared property while their divorce is pending, it explicitly does not restrain changes to or creation of a will, modification of a revocable trust, or the creation of an unfunded trust. Again, consulting an estate planning attorney can help ensure that your estate plan is accurately modified to reflect your wishes regarding how your property should be bestowed.
Expert Legal Guidance for High-Net-Worth Property Division in Silicon Valley
The complexity of dividing a large, diversified investment portfolio magnifies the risk of mistakes that could result in unequal property division and damage your financial future. The family law attorneys at Hoover Krepelka are experienced in navigating the issues associated with complex property division, and we routinely work with highly qualified financial professionals who help ensure our clients have the information and advice they need to safeguard their interests. To schedule your consultation, fill out the form below today.
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FAQs
How are investment portfolios divided in divorce?
Investment portfolios are typically divided based on marital property laws, which may require splitting assets equitably or equally, depending on the state.
What are the tax implications of splitting investments in a divorce?
Transfers made under a divorce settlement are generally non-taxable, but future capital gains taxes may apply when the investments are sold.
How can I protect my investment assets in a divorce settlement?
You can protect investment assets through prenuptial agreements, careful negotiation during the settlement, and by fully documenting which assets are separate property.
