4 Tax Consequences of Ignoring Crypto in Divorce Settlements

In high-stakes divorce cases, the focus is often on finding the assets. But with cryptocurrency, finding the funds is only half the battle. As legal and financial landscapes evolve, attorneys and clients who focus solely on the value of the crypto portfolio, while ignoring the nature of those assets, risk walking into a financial minefield.

Many settlements divide digital assets based on their current market value without considering the latent tax liabilities attached to them. This oversight can lead to a fair 50/50 split that is, in reality, financially disastrous for one spouse.

Here are four critical tax consequences that can devalue a settlement if crypto assets are not properly analyzed and structured.

1. The Capital Gains Trap

The most common pitfall in crypto settlements is treating digital assets like cash. If a spouse accepts $1 million in Bitcoin as their share of the marital estate, they are not just receiving the asset; they are also receiving the cost basis of that asset.

Unlike a bank account, selling cryptocurrency triggers a capital tax event. If the Bitcoin was purchased early at a low value, the spouse who eventually sells that crypto will be liable for the difference between the sale price and the original purchase price.

The Danger: You may agree to a settlement valued at specific date and time, only to find that after you sell the assets, your net proceeds are reduced by 20% or more due to long-term capital gains taxes.

2. Taxable Events on Transfers

The IRS generally considers transfers of property between divorcing spouses as tax-free. There is no immediate tax bill when the crypto moves from Spouse A’s wallet to Spouse B’s wallet. However, this rule comes with a catch that is frequently overlooked: carryover basis.

This means the recipient spouse assumes the original cost basis of the crypto. If the settlement isn’t structured carefully, one spouse might walk away with tax-free cash, while the other walks away with crypto that carries a massive tax liability that was unaccounted for.

The Danger: A direct transfer seems clean on paper, but if you don't adjust the settlement amount to account for the cost basis you are receiving, you are essentially accepting a debt to the IRS that will come due the moment you rebalance your portfolio.

3. The Phantom Tax Bill

Cryptocurrency is no longer just a buy and hold asset; it is often an income-generating vehicle. Through staking, yield farming, or decentralized finance (DeFi) protocols, crypto assets can generate interest.

The IRS has clarified that these rewards are often treated as income and if your spouse has been earning staking rewards that were not properly reported on previous tax returns, you could be inheriting an asset attached to unreported income. Furthermore, you may face a tax bill on new tokens you haven't even sold yet; this scenario is known as phantom income.

The Danger: You could be liable for taxes on assets you didn't know existed, or worse, be forced to sell the underlying asset just to pay the income tax on the rewards it generated.

4. Foregoing Tax-Loss Harvesting

Due to the volatility of the market, many crypto portfolios hold assets that are worth less than their purchase price. A savvy settlement strategy doesn't just look at gains; it looks at losses.

Tax-loss harvesting involves selling these underperforming assets to realize a loss, which can then be used to offset capital gains in other parts of the portfolio. If the assets are simply transferred without harvesting these losses first, the couple may miss a collective opportunity to reduce their overall tax burden before the final decree.

The Danger: By ignoring this strategy, you are leaving free money on the table. An expert can identify which assets are ripe for harvesting, potentially saving both parties thousands of dollars in taxes that can be used to balance the settlement.

Expertise Beyond Discovery

At BlockSquared Forensics, we know that finding the hidden crypto is just step one. True forensic value lies in understanding the complete financial picture. We don't just trace the coins; we analyze the cost basis, the income history, and the tax exposure of every wallet.

A financially sound settlement requires more than a spreadsheet of balances, it requires a strategic partner who can navigate the complexities of the blockchain. Ensure your settlement is truly equitable by factoring in the inevitable call from the IRS.