With the filing status, child-related tax concerns and spousal support issues understood, there are some additional tax implications you might consider when dividing your assets.
Sale of the Primary Residence
If there is a marital home that may be sold upon divorce, or in the years following, remember that married taxpayers can exclude up to $500,000 of gain while single taxpayers can only exclude up to $250,000 of gain. Those thinking that they’ll figure out what to do with the house after the divorce is finalized may be in for a rude awakening.
Under IRC §1041, transfers of property between spouses during marriage, or former spouses if the transfer is incident to divorce, are tax-free. No gain or loss is recognized and for tax purposes, the transferee’s basis and holding period in the property become the adjusted basis and holding period of the transferor. To qualify as incident to divorce, the transfer must occur within one year after the divorce, or, be pursuant to the divorce decree and occur within six years after the divorce.
The Importance of Knowing Cost Basis and Previously Claimed Tax Benefits
While property transfers from one spouse to the other incident to divorce are not taxable, it is important to remember that the cost basis transfers along with it. This means that a $20,000 savings account may be worth more than a $20,000 stock portfolio with a low basis, since taxes still need to be paid on the gains once the stock is sold.
Of course, the same is true for retirement assets as opposed to cash or highly liquid assets. Funds in a pre-tax retirement account are subject to taxes upon distribution, plus a penalty if withdrawn early, whereas cash sitting in a checking account has already been taxed. It can be useful to consider asset division on both a pre-tax and after-tax basis to ensure the division is truly equitable.
It is also important to keep any previously taken tax benefits in mind when dividing business assets. For example, if a spouse owns a business with a vehicle that has been partially depreciated and the vehicle is then transferred to the other spouse pursuant to the divorce, the spouse receiving the vehicle will be subject to recapture for the depreciation that has been previously claimed.
Reporting Dividends, Interest and US Bonds
When joint assets, such as savings or brokerage accounts, are divided, there may be reinvested dividends or interest that will cause a Form 1099 to be issued to the original owner spouse. If that asset is then transferred to the other spouse who then gets the benefit of the accumulated income or reinvested dividends, then it should be noted on the original owner spouse’s income taxes (Schedule B of the 1040). The full amount of dividends and interest should be reported, with an explanation on the line below indicating “Paid to nominee (ex-spouse name and SSN)” with that same amount shown as a negative number. Then, of course, the new owner spouse should be provided with either a copy of the Form 1099 or the amount they must report as the nominee recipient.
There are also special rules for reporting US bonds. When they are transferred pursuant to a divorce the transferor must include any accrued interest on his or her tax return when they are reissued. When they are eventually redeemed, the recipient spouse will report the total interest from the 1099 and then on a separate line, subtract the interest that the transferor already reported.
Transfer of Retirement Assets
Spouses planning to divide retirement assets need to do so carefully. The transfer of IRA assets can be handled simply by spelling it out in the divorce settlement. However, transfers of qualified account assets, such as a 401(k) or defined benefit plan, require a qualified domestic relations order (QDRO).
The QDRO can also provide needed liquidity at the time of divorce based on IRC 72(t)(2)(C), which states that funds may be distributed from a retirement plan without being subject to the usual 10% early withdrawal penalty. The distribution must be made pursuant to a divorce, paid to an alternate payee under a QDRO, and be made directly from the plan that is the subject of the QDRO. Any distribution will still be subject to income tax.
During divorce, important financial negotiations are set against a backdrop of significant emotional chaos, often with disputes over money being one of the factors leading to divorce. This makes financial decision making difficult at best. Yet, depending on their stage of life, these are among the most important financial decisions individuals will ever make.
The new single-status reality is that lifestyles will have to change (agh!), account values will fluctuate – for better or worse, and taxes still have to be filed and paid. When both parties have a clear understanding of the tax implications surrounding their options, better decisions can be made in creating the best and most sustainable agreements for support and asset division.