When settling a marital estate, it’s important to consider tax issues — especially as federal tax laws are expected to generally become less favorable with the change of administration. According to current tax law, child support payments and alimony payments made under agreements executed after 2018 aren’t deductible by the paying spouse (or taxable to the recipient). But what are the tax implications of transferring marital assets between spouses when a divorce is settled and beyond?

Most Transfers Are Initially Tax-Free

Divorcing spouses can divide most assets, before a divorce or at the time it become final, without any federal income or gift tax consequences. Tax-free treatment also applies to post-divorce transfers as long as they’re made incident to divorce. The spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

An exception to the tax-free transfer rule is qualified retirement plan accounts, such as 401(k), profit-sharing or pension plan accounts. The commonly preferred method to handle these assets is to set up a “qualified domestic relations order” (QDRO). Without a QDRO, transfers of account assets between spouses may, in the year received, be subject to unfavorable tax treatment.

Post-Divorce Tax Issues Are Critical

After the divorce is finalized, there may be tax implications for assets received tax-free in the divorce settlement. The person who winds up owning an appreciated asset — where the fair market value exceeds the tax basis — generally must recognize taxable gain when the asset is sold, unless an exception applies.

Appreciated assets come with a built-in tax liability. So, from a net-of-tax perspective, appreciated assets may be worth less than an equal amount of cash or other assets that haven’t appreciated.

Different Assets, Different Treatments

The spouses’ former home is a common example of an asset that appreciates over time. Taxpayers can generally exclude from federal taxable income gains of up to $250,000 ($500,000 for married couples who file a joint return) on homes, as long as they’ve owned and used the property as their principal residence for two of the previous five years. If a taxpayer doesn’t meet the two-year ownership and use tests, any gain from the sale may qualify for a reduced exclusion due to unforeseen circumstances.

If one spouse continues to live in the home and the other moves out (but both remain owners), they may still be able to avoid gain on its future sale (up to $250,000 each). However, special language must be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out.

Other appreciable assets — such as vacation homes, investment properties, stocks and bonds, and private business interests — don’t receive this favorable tax treatment. Instead, these appreciable assets are typically subject to capital gains tax when they’re sold, assuming the assets are held for longer than a year. Beware: Capital gains tax rates are expected to increase for high-income individuals with the change of administration. 

Always Factor Taxes Into Settlements 

The federal tax rules are complicated — and some are expected to change in the coming years. Achieving an equitable divorce settlement often requires the input of an experienced tax professional to determine the tax-equivalent value of marital assets.

 

    theKFORDgroup litigation team holds extensive knowledge and experience in expert witness engagements, forensic accounting, and business valuations. Our experts are trained and experienced in both the tax and the litigation process. We can help with the tax issues in your next case. For more information, please call us at 210-340-8351. 

    Additional information included in this report was provided by PDI Global/Thomson Reuters  © 2021

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