(Part 8 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)
C. Losses And Other Carry Forwards
Tax losses and other carry forwards such as investment interest expense are easy to overlook in divorce proceedings, but often may be of extreme economic value. Remarkably, in many cases the tax law offers no specific guidance as to how such items are to be allocated between divorcing spouses. In such cases the practitioner must fall back on the general rules governing state property law, be it community property, equitable distribution, case law where available, English Common Law, or if all else fails, common sense.
1.Carry Forwards of Net Operating Losses
a) Community Property States
In community property states, the allocation of net operating loss carry forwards follows the usual rules for allocating community 
(1)Earned income is split evenly between spouses
(2)Rules for unearned income vary by state
(3)Expenses paid out of community funds are split evenly
(4)Expenses paid out of separate funds are allocated to the spouse who pays them (54)
Lucy and Ricky filed a joint tax return in 2015. At that time, they resided in California, which is a community property state. The return showed a net operating loss for the year of $10,000 from Ricky’s Schedule C business of being a band leader. Lucy played no part in the operation of the business. In 2016 Ricky and Lucy divorced. The net operating loss carry forward would be allocated as follows:
b) Non-Community Property States
In non-community property states, the net operating loss carry-forward belongs to the spouse who generated it. If both spouses generated the net operating loss, then the amount of carry-forward available to each spouse must be calculated by computing the ratio of the loss, against what each spouse’s separate income would have been if each spouse had filed separate tax returns for the year in which the NOL was generated.(55)
Example: Assume the same fact as the above example except that Lucy and Ricky lives in a non-community property state and they both actively participate in Ricky’s business. Additionally, they each have other income and deductions from separate property. If Lucy’s deductions exceed her income by $3,000 and Ricky’s deductions exceeded his income by $7,000, then the net operating loss carry forward for 2016 would be allocated as follows:
Net Operating Loss Generated in 2016…………………$10,000
Ricky’s 2016 Excess Deductions Over Income………. <$7,000>
Lucy’s 2016 Excess Deductions Over Income………. <$3,000>
Amount of NOL Carry Forward Awarded to Ricky…. <$7,000>
Amount of NOL Carry Forward Awarded to Lucy……<$3,000>
Note: In reality, a couple’s net operating loss may be made up of several different items with some belonging to each spouse in whole or in part.
2.Carry Forwards of Capital Losses
a) Community Property States
As with Net Operating Loss carry forwards, capital loss carry forwards for community or jointly held property are allocated under the community property rules in the state in which the couple resides. Generally, this means that the losses will be split equally between the two parties.
b) Non Community Property States
The capital loss carried forward for each spouse in non-community property states must be allocated based on each spouse’s individual share of the loss that is generating the loss carry forward.
Example: Assume for 2015, Fred and Wilma have a $15,000 long term loss from property owned by Fred and a $5,000 short term loss from property owned by Wilma. The couple file a joint return for 2015, but are divorced on July 15, 2016. On their 2015 tax return, they deducted a $3,000 short term loss. The capital loss carried forward should be allocated as follows:
Short Term Capital Loss $ 0 $2,000
Long Term Capital Loss $15,000 $ 0
Total ($17,000) $15,000 $2,000
3. Carry Forwards of Charitable Contributions
Charitable contribution carry forwards must be allocated proportionally between the spouses by performing a look back calculation in the year that the charitable contribution carry forward was generated.
Example: Fred and Ethel filed a joint return in a community property state for 2016. Due to Adjusted Gross Income Limitations, they had $100,000 in charitable contributions carry forwards. In order to determine the allocation of the carry forward into the future, proforma 2016 returns must be generated using the married filing separately filing status. These returns are for computational purposes only and will not be filed. It is determined from the proforma married filing separate returns, that had the original returns for 2016 been filed using the married filing separately status, the allocation of the charitable contributions carry forward would have been an equal division meaning each party would be entitled to $50,000 ($100,000/2).
Tax Trap Alert: It is possible to get disparate and inequitable results in the carry forward allocation due to the differences in adjusted gross income with married filing separate returns as opposed to a joint return. For example, on a joint return, one spouse may have a loss on a sole proprietorship that can be used to offset some of the W-2 wages of the other spouse. As of the date of this writing, there is no published guidance on this matter of which the author is aware. Therefore, it would appear that other than asking IRS for an expensive and time consuming Private Letter Ruling, the practitioner must rely on his/her own best judgement.
4. Carry Forwards of Suspended Passive Activity Losses
a) With some exceptions, losses from passive activities re limited to the extent the taxpayer has income from such passive activities.(59)
b) Losses that are not currently deductible are generally carried to future years. Such losses are known as Suspended Passivity Losses and often have significant intrinsic economic value.
Example: Ricky and Lucy have a non-working interest in an oil and gas partnership named Lucky Strike. They also have a non-working interest in a gold mining partnership named Old Gold. For 2015, Old Gold passed through $75,000 in ordinary income to Lucy and Ricky, while Lucky Strike passed through $85,000 in ordinary losses to them. They can use $75,000 of the Lucky Strike loss to offset the $75,000 of income from Old Gold. The remaining $10,000 of the Lucky Strike loss is suspended and carried forward indefinitely, or until the complete disposition of the underlying interest.
NOTE: Special rules apply to suspended passive losses when they are disposed of by gift, or transferred at death.
C. Suspended Passive Losses In Divorce Situations Generally Are Added To Recipient’s Basis In The Underlying Property.
(1) Transfer of property incident to divorce are treated as gifts.
(2) Suspended losses of passive activities disposed of by gift must be added to the basis of such gift.(63)
With planning, the allocation of passive losses incident to a divorce may present the opportunity for significant tax savings. For example, if one spouse is expected to have future passive income after the marriage, an overall tax savings may be achieved by having that spouse maintain the ownership of the property generating the passive losses, thus allowing the passive losses to offset the passive income. The concomitant tax savings taken as a whole could free up the cash flow of the post marital estate, thus (where applicable) allowing for enhanced payments of alimony and child support.
d) Losses of S Corporations (To Be Continued In Part 9 of Series)
Have a question? Contact David Ellis, Ellis & Ellis CPAs.
(This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use. No advisor/client relationship exists.)
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