Over a million Americans will untie the knot this year (about half as many as those who say “I do.”), about half as many as those who say I do. While most in the throes of divorce are too caught up with the business at hand to think of the long-term estate-tax consequences, people should keep their estate plans in mind as they negotiate their settlements. Otherwise, the newly divorced may well find the experience even more taxing than it needs to be.
But first, a little good news.
The IRS generally does not consider the transfer of assets between divorcing spouses to be a taxable event. That includes cash that one spouse pays another as part of the divorce settlement. There are a few restrictions to this rule, of course, but as long as you can demonstrate that divorce — not tax evasion — was the instigating event, you and your soon-to-be ex can transfer cash and assets between you without fear of a tax gain or loss to either party. At least, not in the near term.
In the long run, however, which assets you end up with — and how you got them — can have
serious tax consequences for you. Let’s look at those assets most likely to cause you grief if not handled properly.
Like many couples, you and your spouse may have accumulated assets that will need to be disbursed between you as part of your divorce settlement. Those assets may include mutual funds, stocks, bonds, artwork, or collectibles. If so, great care should be taken as you consider who gets what, or you may set yourself up for a painful capital gains tax bill in the future. Here’s why.
Let’s assume that you and your spouse own shares of a stock that has appreciated substantially since you first bought it. Purchased for $50,000 five years ago, those shares are now worth $100,000. If the two of you decide to sell the shares today, your combined capital gains would be $50,000 — the difference between your original investment and the selling price.
But now say you want to hang on to the stock, and so you pay your spouse $50,000 — half the current market value — for full ownership of all the shares. That brings your total investment in the shares to $75,000.
If you sell the shares, what will be the cost basis used to determine your capital gains
Unfortunately for you, it’s not the $75,000 you’ve actually invested in the stock. Instead, the government will look at your original cost basis ($25,000), and your spouse’s original cost
basis ($25,000) and deem that your actual cost basis is just $50,000!
By the way, the $50,000 you paid for the shares goes to your spouse completely tax-free. So, clearly your spouse got the better end of this deal.
For most couples, their home is their most expensive asset, one which they are likely to own jointly. As you hammer out your divorce settlement, you and your spouse will probably face these three options: Sell your home and split the proceeds now; sell it at some future date and split the proceeds then; or let one spouse buy out the other’s interest in the property. Let’s look at the tax consequences of each option.
Taxpayers have up to two years after selling a home to reinvest in another and avoid paying capital gains taxes on their profits from the sale. But there’s a catch: To be eligible for
the two-year deferral, the home you sell has to be your principal residence.
To give taxpayers some flexibility, the IRS will grant homeowners the exemption as long as they lived in the home at least three years out of the past five. That requirement can prove a source of tax trouble when the divorce settlement allows one spouse to remain in the home for more than two years before it is sold. The non-resident spouse will no longer be entitled to the capital gains
deduction because the home no longer qualifies as his or her principal residence.
On the other hand, if one spouse buys out the other’s interest in the home, the purchasing spouse may have set the stage for a capital gains problem in the future, as we discussed earlier in this article.
If you and your spouse are both over age 55, the timing of the sale of your home becomes even more critical.
That’s because individuals 55 and over can qualify for a capital gains exclusion on up to $125,000. (Married individuals who file separately may only claim $62,500.) If your house has appreciated more than that, here’s a good reason to wait until after you divorce to sell the property. If you do, both you and your ex-spouse will each qualify for a $125,000 exclusion, allowing you to shelter a combined $250,000 from capital gains taxes.
Many couples find that the best solution is to sell the home at the time of divorce and move on, literally and figuratively, older but wiser. But if that isn’t possible in your situation, be sure your attorney takes these tax implications into consideration when negotiating your divorce
Finally, no matter what your age, if your home is owned jointly by you and your spouse, don’t delay too long before either selling it or retitling it into one spouse’s name. Otherwise, if
disaster strikes and you die while you are joint owners of your home, you may inadvertently bequeath your greatest asset to your ex.
Your Retirement Funds
For many Americans, their retirement funds rank high on their list of major assets. Part or all of these assets may be considered marital property, and thus subject to the divorce settlement.
The tax laws governing qualified retirement plans, such as 401(k)s, are strict and limit not only to whom, but also when and how distributions from the plans may be received. Further, the law is equally stringent about the rights of the plan owner’s spouse. It requires that your spouse also receive distributions, and it will not allow you to “alienate” or “assign” your qualified pension plan distributions to anyone else.
So, what happens in a divorce? Even though your spouse is about to become your ex-spouse, he or she will still have rights to some portion of your plan distributions. The solution for divorcing spouses is usually the Qualified Domestic Relations Order (QDRO). If drawn up properly in accordance with the governing tax laws, the QDRO extends to the ex-spouse the same distribution privileges that he or she would have received if still married to the plan
If you are the plan owner, don’t worry that a new spouse will be shut out of benefits, should you remarry. Current spouse and ex-spouse will each receive a proportionate share of your plan
distributions, determined by the length of each marriage and the plan contributions made during those years.
In contrast to qualified plans, the Individual Retirement Account (IRA) is generally considered the sole property of its owner. Of course, that assumes you’ve made no contributions to it from your earnings during the course of your marriage. If you have, then your spouse will have rights to a proportionate amount of IRA assets, subject to your state’s laws governing the distribution of marital assets upon divorce. IRA funds can be transferred tax-free from one spouse to another by a written divorce decree.
If you’re the recipient of these funds, be forewarned, however: You should have the IRA Trustee roll the funds into your own IRA. Otherwise, if you take “constructive receipt,” or have the
funds paid to you directly, you may be liable for a 20 percent standard withholding for federal income tax.
Other Taxing Issues
Dependency Exemption for Children.
As in most divorce settlement negotiations, you and your spouse will probably have several bargaining chips on the table. One may be the dependency exemptions for any children you may have. These exemptions mean the most to lower- and middle-income taxpayers, providing very little in the way of tax relief to high-income Americans, as a result of the deduction phase-out. But often after divorce, there may well be a significant disparity in earnings between you and your spouse. In that case, the dependency exemption may become a chip worth bargaining
Unless there’s a decree stipulating otherwise, the custodial parent is generally entitled to the dependency exemption. That can be changed, however, if the custodial parent releases the
exemption by filing IRS form 8332. Regardless of who has custody, both parents may able to deduct medical expenses. However, only the custodial parent may take the child care credit.
Married filing separate is the most costly filing status available. That’s why, if you and your spouse can agree to it, you may want to continue filing jointly until your divorce is final.
There are two notable exceptions to this rule, however.
You probably shouldn’t file jointly if your spouse has incurred taxes that he or she won’t be able to pay. By filing jointly, you assume liability for your spouse’s taxes as well as your own. If the IRS can’t get satisfaction from your spouse, it will turn to you for payment.
Also, you may not want to file jointly if you suspect that your spouse isn’t fully disclosing income or is falsifying deductions. Once again, you may be held liable for your spouse’s tax liability, plus associated penalties.
An alternative option that may be open to you if you have children at home is the head of household filing status. You can qualify for head of household if you contribute more than half the cost of maintaining your home, your spouse has not have lived with you for the last six months of the year, and you have at least one child living with you.
Your Existing Estate Plan.
Even if you and your soon-to-be ex-spouse remain on the best of terms, you’ll probably want to change your existing estate plan to reflect your new marital status. In some states, you won’t have a choice. Some states have statutes which revoke any provisions that mention your former spouse in your will. That’s just as well. Considering that one in five divorced individuals
will remarry within one year — and nearly 50 percent will be remarried in five years — you should probably update your estate plan now, rather than risk disinheriting a future spouse.
Nothing Replaces Expert Help
No one will ever call divorce a pleasant experience, and you may have already spent more time than you care to think about in an attorney’s office. But considering how much is at stake now and for years to come, it may be worth your while to show an estate planning attorney your proposed settlement before you’re stuck with a costly agreement that will continue to hurt, long after your divorce woes are a distant memory.