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Income Tax and Divorce - Carry-Forwards
2005 National Legal Research Group, Inc.

One of the great challenges in litigating property division cases is identifying all of the assets which a court might potentially treat as marital property. In addition to the mostly factual challenge of finding hidden assets, counsel must also face the mostly legal challenge of identifying marital assets which are hiding in plain sight.

One of the more obscure types of marital property is the income tax carry-forward. A carry-forward is a rule of tax law which permits losses taken in one year to be used as a deduction from income in a later year. This rule exists because the federal government is reluctant to allow certain types of losses to be offset against income from other sources, but is more willing to allow those losses to be offset against income from the same source, even if that income is earned in a later tax year.

The most common carry-forward involves capital losses the opposite of a capital gain. The federal government is concerned that capital losses can be easily manipulated to avoid income tax due on other types of income. Federal tax law therefore permits individuals to claim capital losses only for the purpose of offsetting capital gains. I.R.C. 1211. If the gains and losses had to occur in the same tax year, there would be no effective deduction for many losses, as the financial markets are prone to extended periods in which most publicly traded securities suffer losses. To give taxpayers more flexibility to claim capital losses, federal income tax law permits them to be offset against capital gains in future tax years. I.R.C. 1212(b). Thus, for example, a capital loss suffered in the bear market of 2002 could be claimed as a deduction from capital gains recognized in 2003 or later. The amount of the loss recognized in 2002 is known as a carry-forward, because it can be applied against capital gains in later years.

Carry-forwards become relevant under the law of equitable distribution when divorce occurs after a loss is taken on a marital investment. For example, in the above example, assume that the parties divorced at the end of 2002. The 2002 capital loss reduced the amount of marital property to be divided. If the loss was incurred wrongfully by one spouse, it could be charged to one spouse alone as dissipation, but many losses attributable to outside market forces are not incurred wrongfully. See generally Brett R. Turner, Equitable Distribution of Property 6.30 n.862 (2d ed. 1994 & Supp. 2004). Since all major stock market indices suffered losses in 2002, we will assume that the loss was not dissipation. In that situation, the loss is charged to the marital estate as a whole, and normally shared by both parties.

When a cloud is shared, however, any silver lining must be shared as well. In the context of investment losses, the silver lining is the right to claim the loss as a deduction from capital gains in later tax years. But those tax years will occur after the divorce. Federal tax law generally provides that if either spouse takes a capital loss on an individual tax return, that spouse can use the carry-forward on any future individual tax return. If a capital loss is taken on a joint tax return, the carry-forward is allocated between the spouses, based upon which spouse actually suffered the capital loss that is, upon which spouse owned the investment which generated the loss. See generally Treas. Reg. 1.1212-1(c).

However fair the above rules may be to taxpayers who are not being divorced, it is settled in all fifty states that marital property is not divided by legal title. If the federal allocation were binding for purposes of divorce, the net effect would be to allocate the carry-forward by legal title. To avoid this potentially unfair result, spouses who are not assigned the carry-forward by federal law have asked state divorce courts to treat the carry-forward as a marital asset.

Reported Case Law

Reported appellate decisions from four states consider whether a capital loss carry-forward is marital property. All four states agree that such a carry-forward can be a marital asset.

The issue first arose in Mills v. Mills, 663 S.W.2d 369 (Mo. Ct. App. 1983). The husband in that case sold certain stock during the marriage, claiming a capital loss. The court held that the loss gave the husband a capital loss carry-forward of $32,897, and it treated the carry-forward as a marital asset. The appellate court affirmed:

Pursuant to the provisions of 26 U.S.C.A. 1212, only a portion of a long term capital loss can be deducted by the taxpayer each year. Any excess capital loss must be carried forward each year until exhausted. Wife's testimony established that the loss carry forward was generated from the sale of marital property. Husband produced no contrary evidence nor refuted wife's testimony. Consequently, the trial court did not err in finding the long term capital loss carry forward was marital property.

Id. at 372.

Mills also rejected the husband's argument that treating the carry-forward as a marital asset violated the IRS regulation on use of the credit after divorce. The court held:

Husband further asserts that the court's order awarding wife one-half of the loss carry forward violates Treasury Reg. 1.1212-1(c). It is well settled that a state court cannot override federal income tax regulations. Calia v. Calia, 624 S.W.2d 870, 873 (Mo. App. 1981). We have examined the regulation and do not find that the trial court's order violates the regulation in any manner.


This passage considers an important issue, and it calls for more discussion than the court gave it. The husband was making a classic federal preemption argument: Federal law requires that the carry-forward be allocated in a particular way, and it supersedes any contrary provisions of state law.

There are two major problems with any federal preemption argument in the context of the capital loss carry-forward. First, treating the carry-forward as a marital asset is not inconsistent with any provision of federal law. Federal law sets forth a process for determining which spouse is entitled to claim the carry-forward in future tax years, and state law respects that process. Neither Mills nor any other case discussed in this article ordered the IRS to accept an allocation different from the one set forth in the federal regulation. All the courts did was to treat the carry-forward as a marital asset, and divide its value by adjusting the division of other assets, or by making a monetary award.

Second, to the extent that dividing the value of the carry-forward does limit the federal objective in a very indirect manner, that limitation is not improper. Nothing in the federal statute or regulation states an express desire to preempt state equitable distribution law, a step which Congress clearly knows how to take directly. See Uniformed Services Former Spouses Protection Act (USFSPA), 10 U.S.C. 1408 (conditional direct preemption of state equitable distribution and community property law, for purposes of dividing military retirement benefits upon divorce). The issue is therefore one of implied preemption. The Supreme Court has held that state domestic relations laws are subject to implied preemption only in clear cases, when state law poses substantial dangers to an important federal objective. "State family and family-property law must do 'major damage' to 'clear and substantial' federal interests before the Supremacy Clause will demand that state law be overridden." Hisquierdo v. Hisquierdo, 439 U.S. 572, 581 (1979) (quoting United States v. Yazell, 382 U.S. 341 (1966)); see also McCarty v. McCarty, 453 U.S. 210 (1981). The clearest example to date occurs when state law influences the division of military service benefits between service members and their spouses. McCarty. In this situation, the Supreme Court believes that application of state domestic relations law could interfere with important federal concerns regarding compensation of military service members.

The federal interests involved in capital loss carry-forwards are much smaller and less important than the federal interests involved in compensation of military service members. The primary federal interests in the former situation are orderly administration of the internal revenue laws, and avoiding undue loss of federal revenue. Because state courts never attempt to interfere directly with allocation of the carry-forward itself, there is clearly no threat to orderly administration of the Tax Code. For exactly the same reason, there is no loss of federal revenue, for the carry-forward is used only by the person to whom the federal regulation allocates it. No matter what the state court does, the carry-forward is allocated to the same spouse, and the exact same amount of income tax is paid to the federal government.

To find interference with federal interests in the case law treating carry-forwards as marital property, one would have to take the position that one of the federal interests behind the regulation is allocating dollars between divorcing spouses in a manner which the federal government believes equitable. But the allocation policy comes from an IRS regulation, not from the statute itself, and the IRS is not authorized to regulate the fairness of property division between divorcing persons. The fact that the allocation rule is a regulation is highly consistent with the argument that its only purposes are to administer the carry-forward in an orderly manner and to avoid loss of federal revenue.

In addition, the Supreme Court has traditionally been highly reluctant to assume that Congress had any intention of enacting substantive domestic relations legislation. Such legislation would raise strong federalism concerns, as substantive domestic relations law is an area reserved to the states. To avoid the need to confront these concerns directly, the Supreme Court has traditionally refused to construe any federal statute to address substantive principles of domestic relations law unless its language admits of no other possible interpretation. See Ohio ex rel. Popovici v. Agler, 280 U.S. 379 (1930) (despite broad federal statute giving federal courts exclusive jurisdiction over all suits against foreign consuls, state courts were not deprived of subject-matter jurisdiction over divorce actions involving those consuls); Neustein v. Orbach, 130 F.R.D. 12, 14 (E.D.N.Y. 1990) ("It was long ago decided that domestic relations 'belonged' to the States pursuant to their retained police powers as recognized by the 10th Amendment to the United States Constitution"). The carry-forward statute and regulations do not contain the very strong language necessary to establish principles of substantive federal domestic relations law. State courts therefore do not interfere with federal concerns by allocating the value of a capital loss carry-forward between divorcing spouses, through adjusting the division of assets other than the carry-forward itself.

The Missouri Court of Appeals followed Mills in a 1997 decision, holding that the trial court committed reversible error by failing to divide a capital loss carry-forward:

In her fifth point on appeal, mother contends the trial court erred in failing to distribute the substantial passive loss carry-forward created during the marriage and by excluding rebuttal testimony concerning the nature and value of said carry-forward.

Father testified on cross-examination that he had generated a fair amount of a passive loss carry-forward during the marriage. He state [sic] that his 1994 tax return reflected approximately $134,000.00 of passive loss carry-forward. Father produced no contrary evidence on redirect and he put on no rebuttal evidence. His testimony establishes that there was passive loss carry-forward generated during the marriage and as such it is a marital asset which the trial court must divide. Mills v. Mills, 663 S.W.2d 369, 372 (Mo. App. 1983). The trial court, in its extensive Findings of Fact and Conclusions of Law, did not divide the passive loss carry-forward. Mother's point is meritorious.

Silverstein v. Silverstein, 943 S.W.2d 300, 303 (Mo. Ct. App. 1997).

The classification of carry-forwards has also arisen in the courts of New York. The leading decision holds broadly that all forms of carry-forwards can be treated as marital property:

This brings us to the issue regarding the capital loss carry forward. Marital property, which is broadly construed to consist of "things of value arising out of the marital relationship", is not a traditional property concept (O'Brien v. O'Brien, 66 N.Y.2d 576, 583, 498 N.Y.S.2d 743, 489 N.E.2d 712). . . . We therefore conclude, as did the trial court, that a capital loss carry forward accumulated by the parties constituted a marital asset subject to distribution (but see, Cerretani v. Cerretani, 221 A.D.2d 814, 816-817, 634 N.Y.S.2d 228).

Finkelstein v. Finkelstein, 268 A.D.2d 273, 274, 701 N.Y.S.2d 52, 54 (2000). The notion that marital property "is not a traditional property concept," id., is unique to New York; O'Brien v. O'Brien, 66 N.Y.2d 576, 498 N.Y.S.2d 743 (1985), is the leading New York case holding that professional degrees and licenses are marital property, a holding which other states almost universally have rejected. Turner, supra, 6.21. Nevertheless, the end result of Finkelstein is consistent with results reached in other states.

Finkelstein also discussed briefly the manner in which a carry-forward should be valued:

Here, plaintiff's accountant testified that a tax loss carry forward is valuable since it could be used to reduce her tax liability. We disagree, however, with the trial court's conclusion that plaintiff established that the value of this asset was $155,785.60. In this regard, the only definitive value placed on this asset by plaintiff's accountant was $70,000, which represented the reduction in taxes that plaintiff would have had for the years 1996 and 1997. While plaintiff notes that there would still be a balance remaining of the tax loss carry forward that could be used in future years, she fails to identify any testimony by her accountant establishing that value. We note that, to the extent plaintiff's attorneys opined in a post-trial letter that "[they] believe that [$155,785.60] . . . approximately equals the federal and state tax benefit plaintiff would realize from her share of the carryforward," this was not competent to establish the increased value.

268 A.D.2d at 274, 701 N.Y.S.2d at 54. The value of the carry-forward is therefore the amount of tax savings it is likely to generate. This amount should be proven with expert testimony from a tax expert, and not through a post-trial letter from counsel to the court.

Finkelstein expressly rejected an earlier New York case holding that a carry-forward is not a form of "property" at all:

As to plaintiff's contention that [the] Supreme Court failed to award her a credit for the capital loss carry forward, we find no merit. Without determining whether this is marital property subject to equitable distribution, we find that this tax circumstance is not the type of "property" addressed in Domestic Relations Law 236(B). While the statute does list tax consequences as a factor in distribution (see, Domestic Relations Law 236[B][5][d][10] ), we find such consideration to relate only to the consequences of distribution. As to plaintiff's further contention that she was entitled to a greater distribution due to defendant's failed investments, we find her testimony insufficient to even consider it as a factor (see, Domestic Relations Law 236[B][5][d][11]) and that she fully participated in many of these endeavors.

Cerretani v. Cerretani, 221 A.D.2d 814, 816-17, 634 N.Y.S.2d 228, 231 (1995). It seems distinctly odd that New York would be willing to treat a professional degree or license as property, O'Brien, but then would refuse to treat a tax carry-forward as property. Unlike a degree or license, a carry-forward is a legal entitlement which offers guaranteed tax savings in future years. Congress may technically have the power to amend federal tax law on carry-forwards, but carry-forwards have been recognized for years, and there is no politically significant criticism of them. As a practical matter, tax carry-forwards are much more certain, definite, and enforceable than professional degrees and licenses.

If the logic of Cerretani would carry weight in any other state, that state would probably be Indiana, the only American jurisdiction which continues to adhere to the obsolete rule that only vested interests can constitute marital property. But a recent Indiana decision agrees with Missouri and Finkelstein that a capital loss carry-forward is marital property:

Wife also contends that the dissolution court erred by requiring her to reimburse Husband for the increase in his income tax liability caused by the parties' filing of individual 2002 income tax returns. Wife's argument assumes that a tax loss carryover is property that could be subject to allocation in dissolution proceedings, which presents a matter of first impression in Indiana. Only Missouri and New York courts have addressed that question, and both have found that a tax loss carryover is marital property. See Mills v. Mills, 663 S.W.2d 369, 372 (Mo.Ct.App.1983) (holding that a long-term tax loss carry forward was marital property based on the wife's uncontroverted evidence that the carry forward resulted from the sale of stock acquired during the marriage); Finkelstein v. Finkelstein, 268 A.D.2d 273, 701 N.Y.S.2d 52, 54 (2000) (holding that a tax loss carry forward accumulated by the parties constituted a marital asset subject to distribution in their dissolution proceeding).

We agree with Missouri and New York that a tax loss carryover is property subject to distribution in a dissolution proceeding under Indiana Code Section 31-15-7-4. Although the tax loss carryover was not separately listed on Wife's exhibit to the Agreement, the loss was accumulated through stock transactions conducted in Wife's Schwab account, and that account was listed on Wife's exhibit. Moreover, Wife testified that Husband was aware of her tax loss carryover.

Magee v. Garry-Magee, 833 N.E.2d 1083, 1091-92 (Ind. Ct. App. 2005). The court then went on to find that on the specific facts involved, division of the tax loss carry-forward was barred by the specific terms of the parties' antenuptial agreement. (The parties had agreed to file joint tax returns during the marriage if a joint return would result in overall tax savings, and the filing of a joint tax return for the last marital year consumed the entire carry-forward.)

In In re Marriage of Lafaye, 2003 WL 22097675 (Colo. Ct. App. 2003), the wife claimed very late in the trial that a capital loss carry-forward was divisible property. The trial court held that the carry-forward was a division factor, but not an actual divisible asset. "Based on the sparsity of the evidence and argument on this issue," and noting particularly that neither party had cited any authority, the appellate court affirmed. Id. at *6. Lafaye does not appear to hold that a capital loss carry-forward could not be treated as marital property in a future case.

For cases holding that other carry-forwards constitute marital property, see Beard v. Beard, 49 S.W.3d 40 (Tex. App. 2001) (passive activity loss carry-forward under I.R.C. 469), and Dombrowski v. Dombrowski, 131 N.H. 654, 559 A.2d 828 (1989) (charitable contribution carry-forward). See also Thomas v. Thomas, 407 N.W.2d 124 (Minn. Ct. App. 1987) (treating sole proprietorship's tax credit as marital property).


Income tax carry-forwards are not among the things which come immediately to mind when the word "property" is mentioned. Nevertheless, they offer a reliable guarantee of future tax savings to the taxpayer who is able to claim them. In some cases, their value can be measured in five or even six figures. If carry-forwards are not treated as property, then they are allocated under federal tax law according to legal title, and the entire point of equitable distribution is to avoid that form of division. Treating carry-forwards as property is therefore very consistent with the basic goals of equitable distribution.

The cases have only begun to scratch the surface of the various issues of classification and valuation posed by carry-forwards. The capital loss carry-forward is clearly marital property when it arises from a loss suffered through the sale of marital property. The more interesting situation occurs when the carry-forward arises from a loss suffered upon the sale of separate property. The carry-forward does not seem like property acquired in exchange for the loss, as no portion of the loss itself is refunded. It could be argued that the carry-forward is a form of passive income, but this is not really true either; the carry-forward is a reduction in a loss, not a net gain. To the extent that the carry-forward is intended to mitigate the harm inflicted by the original capital loss, there is an argument that the carry-forward is compensation for the loss. This argument is correct if income tax for the year of the loss has not yet been paid, or has been paid with separate funds.

The situation is unclear, however, when the tax bill for the year of the original loss was paid with marital funds. In this situation, if federal income tax law permitted a deduction in the year of the original loss, the tax savings would clearly have been marital; a smaller amount of marital funds would have been spent to pay the tax bill. To make tax manipulation harder, the federal government defers the deduction until a later year when capital gains are present, but it is hard to see how the decision to defer the deduction should change the classification of the tax savings. In other words, this argument suggests that the carry-forward is really a form of deferred income tax refund, and that it should follow the character of the funds used to pay the original tax bill, rather than the character of the underlying loss. Since no reported cases have yet considered this argument, it is difficult to determine how the courts would respond to it.

The value of the carry-forward is clearly the amount of future tax savings it will produce. Since effective tax rates vary greatly according to the specific situations of individual taxpayers, the valuation must probably be made by a tax expert. The court lacks jurisdiction to transfer title to the carry-forward, but the carry-forward can be treated as an asset owned by the spouse to whom federal law assigns it. The other spouse can then be compensated for his or her interest in the carry-forward through an increased award of other property.

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