Tax Considerations in Divorce – Part 2

Often, the most pressing issues that parties have when divorcing is whether any division of assets will cause a tax liability or them. According to the IRS code 1041, most property transfers between spouses incident to divorce are tax-free.  There is no gain or loss recognized as long as the asset is “transferred” not sold and then proceeds transferred.

Any sale of assets, whether during the marriage or during divorce, constitutes an opportunity for the IRS to impose taxes. For this reason, it is best to divide assets and transfer them in-kind to the spouse.

Marital Home

If there is a buyout of the equity interest of one spouse in the marital home because the other spouse is keeping the asset, then there is no condition of sale. This is a transfer of the equity from the spouse keeping the asset to the other future ex-spouse. 

When the spouse keeping the home sells the home and does so as an unmarried individual, the $250,000 exclusion of taxes on any gains realized will still be applied. However, because of the divorce, the other $250,000 exclusion that would also have been applied to the spouse, is no longer applicable. 

If a home is sold during the divorce for a gain above cost basis AND the $500,000 exclusion, parties will pay the long-term or short-term capital gains. That is why it is more tax efficient to sell the home while still married, even if separated and going through the divorce.  As long as the parties are considered legally married on December 31st of the tax year, then they will be able to claim the full exemption. They will also be able to claim the full exemption if they agree to sell the house after final judgment but both remain on title and it is simply a deferred sale. 

Savings and Checking Accounts

The interest earned on high yield savings accounts, CD, treasury bills and notes, as well as any standard checking or savings accounts is considered ordinary income and taxed according to income tax rates for ordinary income.

If assets are divided, the party who receives the balance(s) would need to claim any interest if they are in receipt of the interest as their ordinary income.  However, if the account is divided, only half of the income is reported on each party’s return. 

Brokerage Accounts

For capital gains on sales only of brokerage accounts parties must claim either short-term or long-term capital gains.  When dividing brokerage accounts, the instructions to the brokerage should be to divide ‘in-kind, pro-rata’ to enable a fair division of the account positions, cost basis and tax liability when either party sells any positions.

The actual division of the account does not cause a taxable event if no positions are actually sold.  If one party sells his or her portion to make an equalizing payment to the other, however, then that party incurs taxes on that portion sold.

It is important that the accounts be divided BEFORE any payments for offsets or equalizations are made.  This ensures that the sale will be reported on the 1099 associated with the seller’s account and not the jointly held account or the account that contains community or marital property.  Upon division, the divided, individual accounts are considered “separate property” as the owners have full ability to sell, recharacterize, or reallocate any positions in the account. 

It is also important that the brokerage accounts are divided pro-rata. That means that any unrealized gains held in certain positions are equally shared and avoids one party receiving the low-basis shares while the other receives the high-basis shares and the unrealized gains associated with those positions.

Vesting Community (Marital) Property during Pendency of Divorce

If there are Restricted Stock Units  (RSUs) or similar community property equity awards that vest during the pendency of the divorce, there will be tax withheld by the employer and this is done automatically upon vesting and shown on the employee’s pay stub. This may not be sufficient tax due on the vested units, however, resulting in the additional taxes owed.  These taxes should be considered in the NET amount of RSUs awarded as the non-employee spouse’s share of these equity awards.

In addition, there may be taxes due at tax time for these vested shares if an insufficient amount was withheld by the employer.  These taxes should be equally shared between the parties if the shares will be ultimately awarded to both spouses equally.

Community Income During Pendency of Divorce

Sometimes, form 8958 will need to be completed to allocate the community income earned under one tax ID number for assets that will be ultimately divided and awarded to both parties.  This form is important if any assets are held only in one taxpayer’s name and the parties are filing separately.  It is important if assets are sold in investment accounts for the purpose of paying off debt during the divorce or for other purposes that benefit both parties, such as to pay for legal bills incurred for the parties either jointly or individually. A tax professional should be consulted to properly identify when to use this form and how to report these transactions during the pendency of divorce.

Retirement Accounts

The transfer of assets from either a traditional ERISA (qualified account) account such as a 401(k) or 403(b) account will be accomplished through a Qualified Domestic Relations Order prepared and submitted to the plan’s administrator. 

Unless there is a withdrawal from the retirement account, there is no tax implication associated with the transfer of retirement assets via QDRO.  Any distribution at the time that the QDRO is prepared and the account is segregated will invoke ordinary income taxes on the amount distributed and these will be the responsibility of the alternate payee (recipient).

There is a waiver of the 10% penalty that is typically assessed on retirement accounts that are withdrawn before the age of 59.5 years of age if the withdrawal is incident to divorce.   

It is important to note that traditional IRA accounts that are transferred from one spouse to the other (after final judgment is received) are not subject to taxes either. However, if any party at any time withdraws from an IRA account, the amount withdrawn is subject not only to ordinary income tax rates, but if the recipient is under age 59.5, a 10% penalty is administered for early withdrawal of these funds.

Other Investment Property & Real Estate

If any other investments or real estate properties are SOLD not simply transferred via an Interspousal Transfer Deed or through the brokerage transfer of funds, there will be tax implications just as for any other sale that may have occurred during the marriage.

It is critical to submit Interspousal Transfer Deeds to avoid the mishap of the county erroneously reassessing the tax base on real properties.  The county recognized transactions between spouses as non-taxable events. This deed vs. a quit claim deed will help to ensure that there is no step up in the tax base for the assessor nor any transfer taxes assigned to the transaction.

There are many tax considerations during divorce especially if the parties are unaware of how to avoid ANY taxes being imposed on the division and transfer of assets. Many divorces do not incur taxes due to the IRS provision but parties need to be aware of how to inadvertently create a taxable situation for themselves as they navigate this process. It is crucial to involve a tax professional throughout the pendency of the divorce.

 This article does NOT constitute legal advice and is for general information purposes ONLY. Prior to making any decisions, seek legal counsel from a licensed attorney.