Tax-Planning Tips for Divorcing Couples
Tax planning for property settlements and financial support
One of the most important aspects of divorce is how to divide assets and property between spouses, and that's not as cut-and-dried as it might seem on the surface. In addition to who gets what, there are numerous tax implications. And that means it's time to do some serious tax planning.
The First Steps
“Courts require full disclosure of income, assets, and debt,” according to Susan Carlisle, CPA. Full disclosure means all of your financial information must be up to date, complete, and truthful. Carlisle advises that people facing divorce:
- Bring their bookkeeping and tax returns up to date.
- File any unfiled tax returns.
- Get copies of bank statements, tax returns, loan documents, and other financial paperwork.
- Gather documents related to real estate, and note who is on the title to each property.
Consider hiring a forensic accountant even if you're already working with a tax professional to prepare your tax returns. Forensic accountants are specialists in the type of accounting needed for courts and law enforcement.
Communicate honestly and openly with your accountant during your divorce. If you and your spouse already have an accountant who prepares your tax returns, your accountant will have a conflict of interest when it comes to providing both of you with advice. Just as each spouse hires his or her own attorney, having separate accountants frees the accountant from having any possible conflict in providing you with professional advice.
Tax Planning Issues for Property Settlements
"Generally, there is no recognized gain or loss on the transfer of property between spouses, or between former spouses if the transfer is because of a divorce," the IRS states in Publication 504, Divorced or Separated Individuals. Property transfers between spouses or former spouses are treated as gifts.
Although you're not immediately taxed when the property is transferred between you and your spouse, whoever sells the property might incur taxes.
Your Primary Residence
If and when the house is sold, the spouse selling the house might be able to exclude up to $250,000 in capital gains if he owned and lived in the house for at least two years in the five-year period leading up to the date of sale. This $250,000 exclusion is for each owner of the house. Any gains above that would be taxable.
Suppose both spouses own the house, and the house has potential unrealized gains of $400,000, which is calculated by taking the house’s current appraisal value and subtracting it from the original purchase cost. If the house is transferred to one spouse and the other spouse is removed from the title, then the owner of the house will be sitting on $150,000 of potential taxable gains — $400,000 less the $250,000 exclusion for one owner.
But there's the potential to exclude the full $400,000 of gains. One possible tax strategy is for both spouses to stay on the title after the divorce. This gets the divorcing couple an exclusion of $500,000, rather than $250,000 if only one person remained on the title. The divorcing couple would have zero potential taxable gains on a profit of $400,000 after the $500,000 exclusion.
This strategy works because of an exception for divorcing spouses when meeting the use test for taking the exclusion. "You are considered to have used property as your main home during any period when you owned it and your spouse or former spouse is allowed to live in it under a divorce or separation instrument and uses it as his or her main home," according to the IRS in Publication 523, Selling Your Home.
There's no tax when transferring assets in a retirement plan, but the tax will be due when funds are distributed from the plan.
Splitting up a 401(k) plan or similar pension account requires a qualified domestic relations order (QDRO). A QDRO is a "court order that assigns rights of an employee with a retirement plan to transfer some or all of the benefits to an alternate payee/spouse. It is sent to the plan administrator to divide the plan according to certain criteria," Carlisle says. How the 401(k) account is split is "spelled out in the QDRO."
In Publication 575, Pension and Annuity Income, the IRS notes, "A spouse or former spouse who receives part of the benefits from a retirement plan under a QDRO reports the payments received as if he or she were a plan participant." The ex-spouse would even be able to roll over his or her share of funds from the retirement plan to another retirement plan.
IRA accounts can be split between divorcing spouses, "essentially rolling assets in one spouse's IRA over to other person's IRA," according to Carlisle. In Publication 590, Individual Retirement Arrangements, the IRS states, "If an interest in a traditional IRA is transferred from your spouse or former spouse to you by a divorce or separate maintenance decree or a written document related to such a decree, the interest in the IRA, starting from the date of the transfer, is treated as your IRA. The transfer is tax-free."
Tax Planning for Securities
There's no tax on the transfer of stocks, bonds, mutual funds and other securities held outside of retirement plans, but the tax will be due when the investments are sold.
"If property is transferred to you from your spouse (or former spouse, if the transfer is incident to your divorce), your basis is the same as your spouse's or former spouse's adjusted basis just before the transfer....The transferor must give you the records necessary to determine the adjusted basis and holding period of the property as of the date of the transfer," according to the IRS in Publication 550, Investment Income and Expenses.
The Concept of Trading Assets
Divorcing spouses will sometimes "trade" assets. For example, one spouse might transfer his or her share of the house in exchange for a portion of the other spouse's retirement assets. But simply adding up all the assets and dividing them in half usually does not result in a fair division of property.
Rather, divorcing spouses will want to discount the value of the assets by the expected taxes due when the assets are sold. In other words, the analysis involves "comparing after-tax dollars for each asset being traded," Carlisle says.
One spouse can provide cash to equalize the after-tax value of the property settlement. "An equalization payment is considered part of the property settlement and not taxable or deductible," according to Carlisle.
Tax Planning Issues for Financial Support
This issue is far more clear cut. Child support is "never taxable, never deductible," Carlisle says. Neither is it taxable income to the parent receiving it.
Alimony or spousal support used to be taxable to the recipient and tax-deductible for the spouse who was paying, but that changed effective Jan. 1, 2019 under the terms of the Tax Cuts and Jobs Act. Divorce agreements entered into and decrees issued before Dec. 31, 2018 are still subject to the old rules, but the law treats alimony as tax neutral after that date. It's taxable income to the spouse that earned it, regardless of whether he hands it over to his ex-spouse.
Planning for Social Security Benefits
Divorced persons can be eligible to receive Social Security benefits based on the former spouse's income. The Social Security Administration says there are five criteria to meet:
- Your marriage lasted 10 years or longer;
- Your ex-spouse is unmarried;
- Your ex-spouse is age 62 or older;
- The benefit that your ex-spouse is entitled to receive based on his or her own work is less than the benefit he or she would receive based on your work; and
- You're entitled to Social Security retirement or disability benefits.
This presents a planning opportunity. Couples might want to delay finalizing their divorce so that they're married for at least ten years. The divorced person "gets their own Social Security benefits or half of ex-spouse's benefits, whichever is higher," Carlisle notes, and this doesn’t affect the other spouse's benefits.
Who Gets to Claim the Kids?
Generally, the parent who has custody of a child for more than half the year will be eligible to claim the child as a dependent. That's because one of four criteria to claim a qualifying child as a dependent requires that the child reside in the same home with the person claiming the child for more than half the year. If the child resides exactly 50% of the time with each parent, the right to claim her goes to the parent with the highest adjusted gross income (AGI).
Giving the Dependent to the Other Parent
The parent with whom a child resides for more than half the year can allow the other parent to claim the child. This process is called releasing the dependent's exemption, and it's accomplished by completing and signing Form 8332 so the other parent can submit it with her tax return.
If you do agree to release the child's personal exemption, be sure to abide by your agreement. If for some reason both parents try to claim the same child as a dependent, the IRS will get involved to try to figure out which parent is truly eligible. You can avoid such IRS scrutiny by sticking to your agreed-upon arrangement for claiming dependents.
Hopefully, these insights will help you plan your taxes when going through a divorce. Consult your tax professional to see how these techniques can be used in your particular situation.
Susan Carlisle is a forensic certified public accountant specializing in family law and taxes in Los Angeles, California.