Capital gains taxes can be the silent wealth destroyer in high net worth divorce—the factor that transforms what appears to be an equal division into a dramatically unequal outcome. When one spouse receives a $5 million stock portfolio with minimal tax basis and the other receives $5 million in cash, they haven’t received equal value at all. One has $5 million, while the other has perhaps $4 million after taxes. Understanding capital gains tax implications isn’t just important—it’s essential to ensuring divorce settlements are truly fair rather than merely appearing equal on paper.
If your divorce involves appreciated assets like investment portfolios, real estate, business interests, or other holdings with substantial built-in gains, understanding capital gains tax treatment under Texas law is critical to protecting your financial interests.
Capital Gains Tax Basics
Capital gains taxes apply when you sell an asset for more than your “tax basis”—generally what you paid for it:
Short-term capital gains: Assets held one year or less are taxed as ordinary income (up to 37% federal rate, plus 3.8% net investment income tax = 40.8% maximum federal rate).
Long-term capital gains: Assets held more than one year are taxed at preferential rates:
- 0% for taxpayers in lowest tax brackets
- 15% for most taxpayers (taxable income under $492,300 single/$553,850 married for 2024)
- 20% for high earners (above those thresholds)
- Plus 3.8% net investment income tax (NIIT) for high earners
- Maximum federal long-term capital gains rate: 23.8% (20% + 3.8%)
Texas advantage: Texas has no state income tax, meaning Texans avoid the 5-13% state capital gains taxes that residents of California, New York, and other high-tax states pay. This is a significant benefit that should inform settlement strategies.
Tax basis: Your basis typically equals:
- Purchase price paid
- Plus capital improvements (for real estate)
- Plus transaction costs
- Minus depreciation claimed
Example:
- Purchased stock for $1 million (basis)
- Now worth $5 million (fair market value)
- Built-in gain: $4 million
- Tax on sale (23.8%): approximately $952,000
- Net after-tax proceeds: $4,048,000
Why Capital Gains Matter in Divorce
Divorce asset division often involves assets with vastly different tax characteristics:
Scenario 1: The Apparently Equal Division
Husband receives:
- Family business worth $5 million (basis: $100,000)
- Built-in gain: $4.9 million
- Future tax liability if sold: $1,166,200 (23.8%)
- After-tax value: $3,833,800
Wife receives:
- Primary residence worth $3 million (tax-free under primary residence exclusion, see below)
- 401(k) accounts worth $2 million (tax-deferred, taxed as ordinary income on withdrawal)
Is this equal? Not really. Wife has $3 million tax-free plus $2 million pre-tax (perhaps $1.3 million after-tax assuming 35% ordinary income rate on retirement withdrawals = $4.3 million total after-tax). Husband has $3.8 million after-tax. Wife receives $500,000 more after-tax value despite “equal” $5 million gross division.
Scenario 2: The Stock Portfolio Problem
Wife receives:
- Highly appreciated stock portfolio worth $4 million
- Basis: $500,000
- Built-in gain: $3.5 million
- Tax on sale: $833,000
- After-tax value: $3,167,000
Husband receives:
- Recently acquired real estate worth $4 million
- Basis: $3.8 million
- Built-in gain: $200,000
- Tax on sale: $47,600
- After-tax value: $3,952,400
The difference: $785,400 in after-tax value despite equal gross values. Husband received dramatically more value because his assets have minimal built-in gains.
Section 1041: The Divorce Tax Break
Congress recognized that divorce asset transfers could trigger massive tax bills, so IRC Section 1041 provides relief:
The rule: Transfers between spouses or former spouses incident to divorce are not taxable events. No gain or loss is recognized on the transfer itself.
“Incident to divorce” means:
- Transfers occurring within one year after divorce, or
- Transfers required by divorce decree or settlement agreement occurring within 6 years after divorce
What this means practically: You can transfer appreciated assets to your spouse in divorce without triggering capital gains taxes immediately. The appreciation is tax-free at transfer time.
The catch—carryover basis: The receiving spouse inherits the transferring spouse’s tax basis. The built-in gain doesn’t disappear—it transfers with the asset.
Example:
- Husband transfers stock to Wife in divorce
- Husband’s basis: $1 million
- Value at transfer: $5 million
- No tax to Husband on the transfer (protected by Section 1041)
- Wife’s basis in received stock: $1 million (carryover basis)
- When Wife later sells for $5 million, she pays tax on the full $4 million gain
Section 1041 doesn’t eliminate taxes; it defers them to the receiving spouse.
Strategic Implications of Section 1041
The carryover basis rule creates important strategic considerations:
Asset selection matters: In division, you should prefer:
- Assets with high basis relative to value (minimal built-in gains)
- Assets eligible for tax benefits (primary residence exclusion, retirement account rollovers)
- Assets you can hold long-term without selling (deferring tax indefinitely)
You should avoid (or demand premium for):
- Assets with low basis relative to value (large built-in gains)
- Assets you’ll need to sell soon (triggering immediate tax)
- Assets generating taxable income annually (dividends, interest, rents)
Example strategy: If you need liquidity post-divorce and will sell assets immediately, strongly prefer receiving assets with high basis or liquid assets (cash). If you can hold assets long-term, low-basis assets are less problematic.
The Primary Residence Capital Gains Exclusion
Special rules apply to the marital home:
IRC Section 121 exclusion: Up to $250,000 of capital gains ($500,000 for married couples filing jointly) from the sale of a primary residence is tax-free if:
- You owned the home for at least 2 of the past 5 years, and
- You used it as your primary residence for at least 2 of the past 5 years
In divorce context:
Scenario 1—Sell before divorce:
- Married couple sells home before divorce
- Gain: $700,000
- Exclusion: $500,000 (married filing jointly)
- Taxable gain: $200,000
- Tax (23.8%): $47,600
- Tax is minimal on sale before divorce if under $500,000 gain
Scenario 2—One spouse keeps home, sells later:
- Wife keeps home in divorce
- Sells 3 years later (5 years after divorce)
- Gain: $700,000
- Exclusion: $250,000 (single)
- Taxable gain: $450,000
- Tax (23.8%): $107,100
- Much higher tax than if sold during marriage
Scenario 3—One spouse keeps, other moves out:
- Wife keeps home
- Husband moves out at separation (2020)
- Divorce final 2021
- Wife sells in 2025
- Husband hasn’t lived there since 2020 (5 years)
- Wife gets $250,000 exclusion, but Husband doesn’t meet 2-out-of-5-years test for his half
- Partial exclusion issue
Strategic planning: Consider timing of home sales relative to divorce to maximize exclusion benefits. Selling before divorce often provides better tax outcomes than one spouse keeping and selling later.
Retirement Accounts: Different Tax Treatment
Retirement accounts have special rules:
Qualified Domestic Relations Orders (QDROs): Allow tax-free division of 401(k)s, pensions, and similar qualified plans between spouses. The receiving spouse gets their own account with their own basis.
IRA transfers: Can be transferred between spouses “incident to divorce” tax-free under Section 1041.
Tax treatment: Retirement accounts are tax-deferred, not tax-free. Future withdrawals are taxed as ordinary income (up to 37% federal), not capital gains rates (23.8% maximum).
Valuation consideration: $1 million in a 401(k) is worth only $650,000-$700,000 after-tax (assuming 30-35% tax on eventual withdrawal). Compare this to $1 million in a brokerage account with high basis (minimal taxes) or $1 million in a Roth IRA (tax-free withdrawals).
Don’t compare retirement accounts to after-tax accounts dollar-for-dollar. The tax treatment differs dramatically.
Calculating After-Tax Values
Proper divorce asset division requires calculating after-tax values:
Step 1—Determine fair market value: What the asset could sell for today.
Step 2—Determine tax basis: What you paid, plus improvements, minus depreciation.
Step 3—Calculate built-in gain: FMV minus basis.
Step 4—Estimate tax rate: Consider holding period (short-term vs. long-term), income level, state taxes (none in Texas), and NIIT.
Step 5—Calculate tax liability: Built-in gain × tax rate.
Step 6—Determine after-tax value: FMV minus tax liability.
Example—Stock portfolio:
- FMV: $3,000,000
- Basis: $400,000
- Built-in gain: $2,600,000
- Tax rate: 23.8%
- Tax liability: $618,800
- After-tax value: $2,381,200
Example—Recently purchased real estate:
- FMV: $3,000,000
- Basis: $2,850,000
- Built-in gain: $150,000
- Tax rate: 23.8%
- Tax liability: $35,700
- After-tax value: $2,964,300
The difference: $583,100 in after-tax value despite equal gross values.
Texas Approach to Tax Liability in Asset Division
Texas courts recognize that built-in tax liabilities affect asset values:
The principle: Courts should consider tax consequences in dividing property to achieve fair results.
However, application varies:
- Some courts explicitly adjust values for tax liabilities
- Others consider taxes as one factor among many in determining “just and right” division
- Courts generally won’t make adjustments for speculative or remote tax consequences
When courts are most likely to consider taxes:
- Immediate tax consequences (assets must be sold promptly)
- Substantial, certain tax liabilities
- Clear disparity in tax treatment between asset classes
- Expert testimony quantifying tax impacts
When courts may not adjust:
- Speculative future taxes (decades away)
- Where both parties receive mixed assets with varying tax characteristics
- Small or uncertain tax differences
Strategic implication: Present clear expert testimony on tax consequences. Don’t assume courts will automatically adjust for taxes—you must prove the impact.
Timing Strategies for Tax Optimization
When assets are divided matters for tax purposes:
Sell during marriage (before divorce):
- Advantages:
- Higher primary residence exclusion ($500k vs. $250k)
- Can file joint return (often lower rates)
- Can offset gains and losses between spouses
- Disadvantages:
- Accelerates tax payment
- Loses opportunity for future appreciation
Sell after divorce:
- Advantages:
- Defers tax payment
- Each spouse controls their own asset disposition
- Potential for further appreciation
- Disadvantages:
- Lower primary residence exclusion
- Can’t offset gains/losses between ex-spouses
- Separate returns typically mean higher rates
Strategic planning: Model different scenarios with your tax advisor to determine optimal timing.
Step-Up in Basis at Death
An important consideration for long-term planning:
The rule: When someone dies, their assets receive a “step-up” in basis to fair market value at death. Built-in gains disappear.
Example:
- You receive stock in divorce with $1 million basis and $5 million value ($4 million built-in gain)
- You hold until death 30 years later when it’s worth $20 million
- Your heirs inherit with basis of $20 million (FMV at death)
- The entire $19 million appreciation is never taxed
Strategic implication: If you can hold appreciated assets until death, capital gains taxes can be avoided entirely through step-up. This favors receiving appreciated assets if you don’t need immediate liquidity and have other assets for living expenses.
Asset Location Strategy
Where assets are held affects taxes:
Tax-advantaged accounts (401k, IRA, 403b):
- Grow tax-deferred
- Withdrawals taxed as ordinary income
- Required minimum distributions after age 73
- No capital gains treatment
Taxable brokerage accounts:
- Dividends and interest taxed annually
- Capital gains taxed only when realized (on sale)
- Long-term capital gains preferential rates apply
- Can hold indefinitely to defer taxes
Roth IRAs:
- Grow tax-free
- Qualified withdrawals are completely tax-free
- Most valuable account type from after-tax perspective
In divorce: $1 million in a Roth IRA is worth more than $1 million in a traditional 401(k), which is worth more than $1 million in a taxable account with low basis stocks. Don’t treat these as equivalent.
Dividend and Interest Income Taxation
Ongoing income from assets has tax implications:
Qualified dividends: Taxed at long-term capital gains rates (maximum 23.8% including NIIT). Most corporate dividends qualify.
Non-qualified dividends: Taxed as ordinary income (up to 40.8% including NIIT). REITs, MLPs, and some foreign dividends don’t qualify for preferential rates.
Interest income: Generally taxed as ordinary income at full rates (up to 40.8%).
Tax-exempt interest: Municipal bond interest is federal tax-free (and often state tax-free, though Texas has no state income tax anyway).
Strategic implication: Assets generating ordinary income are less tax-efficient than assets generating qualified dividends or long-term capital gains. A $5 million REIT portfolio might generate $300,000 annual income taxed at 40.8% ($122,400 annual tax), while a $5 million growth stock portfolio might generate minimal current income and taxes.
Net Investment Income Tax (NIIT)
High earners face an additional 3.8% tax:
Who pays: Individuals with modified adjusted gross income over $200,000 (single) or $250,000 (married filing jointly).
What’s taxed: The lesser of:
- Net investment income (interest, dividends, capital gains, rents, royalties), or
- The amount by which MAGI exceeds the threshold
In divorce: This additional 3.8% applies to most high net worth individuals on investment income and capital gains, making the effective maximum capital gains rate 23.8% (20% + 3.8%).
Depreciation Recapture
Real estate investments involve depreciation recapture:
The concept: If you claimed depreciation deductions on investment real estate, that depreciation is “recaptured” (taxed) when you sell, at ordinary income rates up to 25% (plus 3.8% NIIT = 28.8% maximum).
Example:
- Investment property purchased for $2 million ($500K land, $1.5M building)
- Claimed $400K depreciation deductions over the years
- Adjusted basis: $1.6 million ($2M – $400K depreciation)
- Sell for $3 million
- Total gain: $1.4 million ($3M – $1.6M basis)
- $400K recaptured depreciation taxed at 25% + 3.8% = $115,200
- $1 million remaining gain taxed at 20% + 3.8% = $238,000
- Total tax: $353,200
In divorce: Investment real estate with claimed depreciation has more tax liability than appreciated stocks with equivalent gains. Factor this into valuations.
The Partnership and LLC Complications
Business entities create special tax issues:
Inside vs. outside basis: Your basis in partnership/LLC interests may differ from your share of the entity’s basis in its assets. This creates complex tax calculations.
Hot assets: Partnerships with “hot assets” (unrealized receivables, inventory, depreciation recapture) can trigger ordinary income even on transfers that would normally be capital gains.
Section 754 elections: These elections can affect basis and tax treatment of transferred partnership interests, either favorably or unfavorably.
Built-in gains: Entity-level appreciation may create tax liabilities that aren’t immediately obvious from FMV.
These require specialized tax analysis with CPAs experienced in partnership taxation.
Strategic Considerations for Asset Selection
When dividing assets, preferences should generally be:
Most preferable:
- Cash
- Assets with high basis (minimal built-in gains)
- Roth IRAs
- Primary residence (under exclusion amount)
- Assets eligible for tax benefits
Moderately preferable:
- Traditional retirement accounts (tax-deferred)
- Moderately appreciated assets you can hold long-term
- Assets generating qualified dividend income
Least preferable:
- Highly appreciated assets you must sell soon
- Assets with depreciation recapture
- Assets generating ordinary income
- Illiquid assets with substantial built-in gains
However, personal circumstances matter: If you won’t need to sell for decades and can benefit from step-up at death, highly appreciated assets are less problematic.
Negotiating Tax-Aware Divisions
Several approaches exist:
Approach 1—Equal after-tax values: Calculate after-tax value of all assets and divide so each spouse receives equal after-tax amounts.
Example:
- Total assets: $10 million gross
- After calculating all tax liabilities: $8.5 million after-tax
- Each spouse receives assets worth $4.25 million after-tax
- This might mean Husband receives $5.2 million gross (low-basis assets) while Wife receives $4.8 million gross (high-basis assets)
Approach 2—Equalization payments: Divide assets equally by gross value but make cash equalization payments to account for tax differences.
Example:
- Each spouse receives $5 million gross value
- Husband’s assets have $1 million more tax liability
- Wife pays Husband $500,000 cash to equalize after-tax values
Approach 3—Offset through unequal percentages: Award one spouse a larger percentage of total community property to compensate for receiving less tax-efficient assets.
Example:
- Wife receives 55% of community property (more tax-efficient assets)
- Husband receives 45% (less tax-efficient assets)
- After-tax values are approximately equal
The best approach depends on available assets, liquidity, and parties’ preferences.
The Tax Professional’s Role
High net worth divorce requires tax expertise:
What tax professionals should analyze:
- Calculate basis and built-in gains for all major assets
- Project tax consequences of different division scenarios
- Model optimal timing for asset sales
- Analyze retirement account tax treatment
- Consider state tax implications (minimal in Texas but important for moves to other states)
- Project future income tax brackets
- Evaluate estate tax considerations
When to engage: Early in the divorce process, before settlement negotiations begin. Tax analysis should inform settlement strategy, not be an afterthought.
Case Study: The Stock Portfolio Disparity
A scenario illustrates tax implications:
The situation: Couple has $12 million in assets:
- $4 million primary residence (basis: $1M, gain: $3M, eligible for $500K exclusion)
- $4 million stock portfolio (basis: $500K, gain: $3.5M)
- $2 million 401(k) (pre-tax retirement account)
- $2 million cash
Proposed division (equal gross value):
Husband receives:
- $4M stock portfolio (basis $500K)
- After-tax value if sold: $3,167,000 ($4M – $833K tax)
Wife receives:
- $4M residence
- After-tax value: $3,407,000 ($4M – $593K tax on $2.5M gain above $500K exclusion)
Plus each receives:
- $1M from 401(k)
- $1M cash
Analysis: Wife’s total after-tax value: approximately $4.7M Husband’s total after-tax value: approximately $4.5M
Tax-adjusted division:
Husband receives:
- $4M stock portfolio
- $1.2M from 401(k)
- $1.2M cash
- Total: $6.4M gross
Wife receives:
- $4M residence
- $800K from 401(k)
- $800K cash
- Total: $5.6M gross
After-tax values are now approximately equal at $4.6M each.
Result: The “unequal” gross division actually produces equal after-tax outcomes, which is truly fair.
The Bottom Line
Capital gains taxes represent one of the most significant—and most frequently overlooked—factors affecting fairness in high net worth divorce asset division. Assets that appear equal in gross value can differ by hundreds of thousands or millions of dollars in after-tax value depending on their tax basis, character, and when they’ll be sold.
Texas’s status as a no-income-tax state provides advantages for residents, as you avoid the 5-13% state capital gains taxes that complicate divorce planning in states like California and New York. However, federal capital gains taxes of up to 23.8% still apply, and these can dramatically affect asset values.
Proper divorce planning requires:
- Calculating tax basis for all major assets
- Projecting tax consequences of disposition
- Considering timing of sales relative to divorce
- Analyzing different asset types’ tax efficiency
- Structuring divisions based on after-tax rather than gross values
For high net worth individuals divorcing in Texas, engagement with experienced tax professionals who can model various division scenarios and project after-tax outcomes is essential—not optional. The difference between tax-aware and tax-blind divorce settlements can easily amount to 15-25% of total asset value, or millions of dollars in a substantial estate.
Don’t accept settlement proposals based solely on gross asset values without understanding the tax implications. An apparently “equal” 50/50 division can be profoundly unequal once taxes are considered, and Texas courts will generally recognize and adjust for these disparities when properly presented with expert tax analysis.
Whether you’re negotiating settlement or preparing for trial, understanding capital gains tax implications and presenting clear expert testimony on after-tax values is one of the most important strategic considerations in protecting your financial interests.
Additional Questions
If you have additional questions, please contact us by telephone at 832-538-0833 to schedule an appointment. Our attorneys have deep expertise in handling high-net worth-divorce cases involving capital gains.
Legal Disclaimer: This article is for informational purposes only and does not constitute legal advice. Divorce laws vary by state, and every situation is unique. For advice specific to your circumstances, please consult with a qualified attorney in your jurisdiction.