Tax Implications of a Divorce

If you're headed for a divorce, have an estate or tax lawyer look over your settlement. Here's why. Over one million American couples will get divorced this year. Between the custody battle for Speckles the Dalmatian and the heated dispute over who gets the house and the yacht, it's important to take a few minutes to consider the tax implications of a divorce settlement. Those who don't could be up a creek without a yacht. The good news is that the Internal Revenue Service doesn't consider the transfer of assets between divorcing spouses a taxable event. Remember, this is the IRS we're talking about, so of course there are restrictions and exceptions to this rule. But in general, if the divorce is the driving force behind the asset transfers (as opposed to a desire to evade taxes), transfers can be made at will with little fear of taxation. Unfortunately, if you transfer assets, the issue of taxes is only assuaged for a short time. In the long run, tax laws, particularly the capital gains tax, are very discriminating about assets you end up with and how you came by them. Below are some common assets that could lead to a capital gains tax mess if not thoughtfully considered before the divorce is completed.

The Home

Most often, the home is the most expensive asset that is owned jointly. Usually divorcing couples arrive at one of three solutions for distributing the home: 1. Sell the home now and divide the proceeds. 2. Do this at a future date. 3. One person buys the other's interest in the property.

When a home is sold, taxpayers have a two-year deadline to reinvest the money if they wish to avoid the capital gains tax. But this two-year deferral only applies if the home is the principal residence. The IRS says that as long as the house has been lived in at least three of the past five years, the two-year deferral applies. A problem arises when an ex-spouse lives in the house for more than two years after the divorce. Some heavy capital gains taxes may be in store for the other spouse when the house is finally sold, because the principal residence rule no longer applies to them.

For those over the age of 55, even more capital gains exclusions apply, making the process of selling a shared asset even more complex. Individuals over 55 may qualify for capital gains exclusions of up to $125,000. If a home is worth more than $125,000 and a divorce is imminent, it is a good idea to wait until after the divorce is finalized before selling the house. That way each spouse may qualify for a $125,000 exclusion, resulting in a combined tax shelter of $250,000.

No matter what the final decision is regarding the home, be sure not to wait too long after the divorce before taking action in either selling the home or transferring the title into one or the other's name.

Mutual Funds, Stocks, Bonds, Artwork and Other Appreciating Items

Most couples amass belongings during their marriage that will need to be divided and disbursed during the course of a divorce. If any of these belongings are appreciating assets, they should be carefully considered in light of the capital gains tax.

Suppose a couple purchased stock some time ago for $50,000 and now, after accumulating value, it is worth $100,000. Because of a divorce, this stock is sold and divided. The capital gains tax would be applied to the profit the stock generated since its purchase, in this case $50,000.

But perhaps instead of selling the stock, one spouse wants to keep it. To do so, they must purchase the other half, paying the other spouse $50,000. This makes the buyer's total investment into the stock shares $75,000. The catch is, for capital gains tax purposes, it doesn't matter that the buyer actually invested $75,000, the government will considers the original cost basis of $50,000! Meanwhile the $50,000 paid to the other spouse goes to them tax-free.

Retirement Funds

Retirement funds often fall at the top of the asset ladder. They can be considered partially or completely marital property and therefore should be taken into consideration during the divorce settlement.

Tax laws regarding qualified retirement plans like 401Ks are very strict and govern not only who receives the distributions, but also how they are handed out. The laws are equally strict regarding the plan owner's spousal rights. The law does not allow you to ascribe your pension plan distributions to anyone other than your spouse, and it doesn't let you stop distributions to that person either.

When divorce occurs, your ex-spouse is still entitled to some portion of the distribution plan. Divorcing couples must usually draft a Qualified Domestic Relations Order (QDRO). When written in accordance with the laws, the QDRO allows the ex-spouse the same distribution that they would have received if still married to the plan owner.
If the plan owner should remarry, don't worry about your new spouse's benefits from the plan. Current and ex-spouses will each receive a proportionate share of the plan's distributions, determined by the length of each marriage and plan contributions made during those years.

IRAs function somewhat differently than qualified plans. An IRA is generally considered the property of its owner. However, this assumes that there have been no contributions from earnings made during the marriage. If there have been contributions during your marriage, your spouse will have rights to some of the IRA assets as determined by state law. Such assets can be transferred tax-free by a written divorce decree. If you are the recipient of transferred IRA assets, be sure to have the funds rolled immediately into your own IRA. If you don't, you could be hit with a 20 percent withholding penalty for federal income tax.

Dependency Exemption

The custodial parent generally gets the dependency exemption when filing taxes. This is usually more important for lower-to-middle-income taxpayers, especially if there is a significant difference between the earnings of the two seeking the divorce. Regardless of custody, both parents may deduct medical expenses.

Because of the long-reaching implications of a divorce settlement, one of the best things to do is get expert help. You may think lawyers are too expensive for such a task, but getting a good estate planning lawyer and divorce lawyer can save you from a costly divorce agreement that could have you paying taxes long after the lawyer fees have been put to rest.

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