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January 28, 2011 by David Bergmann, CFP?
Besides the emotional and relationship issues that divorce presents us with, understanding the tax issues associated with getting a marital dissolution can be challenging. The good news is that where divorce costs might typically not be deductible, legal advice and representation surrounding matters of ‘tax’, ‘investment’, or ‘business and/or production of income property’ involved in the divorce will allow for deductibility of those related ‘divorce’ expenses. The other good news is that, generally, ‘transfers incident to a divorce’ are not taxable events as they have similar transfer rules as lifetime gifts of property where basis and time of property being held by the transferor (donor) are carried over to the new owner, the donee in the case of a lifetime gift, or in the case of marital dissolution, the ex-spouse.
THE PERSONAL RESIDENCE
For example, you and your ex owned your personal residence together and now the court gives you, spouse 1, the home in the settlement. You both paid $100,000 for your home and it is now worth $250,000. Your ex-spouse, spouse 2, would have their name removed from title and the home would transfer without income tax consequences to spouse 1. The home, whenever it sold, would have been considered to have been owned by the selling spouse, spouse 1, for both the married and post marriage time periods in aggregate. That would help in satisfying the two years of ownership rule that gives us special non-recognition of gains on the sale of our property of up to $250,000 for a single person. So, if the aggregate time of ‘use and ownership’ was at least two years and spouse 1 sells the home for $350,000, the $250,000 would be excluded from income.
Many times spouse 2 is told to move out and spouse 1 remains in the home until the youngest reaches age of maturity, graduates from school, or some other criteria, when the house would then be sold and the proceeds distributed to both of the previously married spouses. If spouse 2 remains on title until junior, age 6 reaches age 18, how is he or she going to get the gain exclusion, if a gain is made, since he or she would not have used the home as their personal residence since moving out pursuant to the divorce? The law qualifies spouse 1’s use as use for spouse 2 for purposes of satisfying the code section 121 gain exclusion. So 12 years later spouse 1 sells the home (spouse 1 and spouse 2 remain on title) for, say $600,000 (a $500,000 gain), both spouses would be eligible for the $250,000 gain exclusion under code section 121.
What about spouse 2 paying the home’s (spouse 1’s personal residence) mortgage interest and property taxes. Is that deductible by the non-residing-in-the-home spouse 2? Yes, for the same reasons as the previous paragraph (use), however, there is an overall mortgage interest deduction cap and that is interest upon $1M in ‘acquisition indebtedness’ and $100,000, interest thereupon, of home equity line of credit.
Oh, you still can’t stand the ex (spouse 2) and you would jump at the opportunity to get one last shot in. Well you just heard the ex and his or her new partner are selling the residence he or she was living in while he or she was paying for the home you are living in and he is going to realize a $250,000 gain on the sale of that residence. You promptly sell the home you are residing in with your child (assuming you aren’t legally bound not to) in the same year (or within two years) as he or she is selling their home and wham – only one gain allowed in a two year period, so he or she would be taxed on one of their $250,000 property sale gains.
MONEY EARNED AND FILING STATUS FOR THE YEAR?
As a married couple spouse 1 and spouse 2 filed their tax returns with a filing status of married filing joint or married filing separately. Once they are divorced they are considered divorced for the whole year just as they were considered married the whole year no matter when they got married during the year they married way back when. Well if you are divorced for the entire year who is going to report the income that spouse 1 and spouse 2 have reported to them (1099’s, W-2’s, K-1’s, etc.) for the tax year they got divorced in?
The rules are different for common law states and for community property states. Common law states require ‘equitable distribution’ of the income whereas community property states require that you follow your community property law state’s rules of ‘community income splitting’. Those ‘community income splitting’ rules require that divorcing couples split their income up to the day of the divorce and thereafter their income is separate. Sometimes spouses in community property states have ‘separate’ property. Separate property income in community property states is taxed differently depending on what community property state you live in.
You may be considered divorced for purposes of these rules if you are an ‘abandoned spouse’ or you are legally separated as defined in your state of residence. In this case you may be eligible for head of household or single filing status.
WHAT ABOUT THE KIDS?
While we were married we took on our tax returns our children as dependency exemptions enabling us to derive tax deductibility, and hopefully actual tax benefit, from deductions for their care and upbringing, like education and medical expenses. We may have received a tax credit for each child and we may have received a tax credit for dependent care because both husband and wife were full time employed. What happens when we divorce?
The divorce decree determines custody. If it does not, then custody is determined by which parent has physical custody of the child for the greater portion of the year – the ‘custodial’ parent. The custodial parent gets the dependency deduction. When agreed, the noncustodial parent most often gets the dependency exemption by an executed IRS form 8332 provided by the custodial parent.
The child tax credit goes with the dependency exemption – the person taking the dependent as an exemption on their return gets the child tax credit.
The child (dependent) care credit is available only to the custodial parent and strict rules apply regarding ‘qualifying amounts paid’.
Unlike alimony, money that is paid as child support is not income to the recipient and not deductible by the payor.
WHOSE RETIREMENT ACCOUNT IS IT?
State laws control property divisions. As was stated earlier there are community property states and common law states so exact rules about divorcing spouse rights to retirement account values are controlled at the state level with ERISA rules and other Federal statutes overlaying them. With regard to marital dissolutions and the court order directing a plan’s custodian to assign plan assets to an alternative payee that is accomplished by a ‘Qualified Domestic Relations Order’ (QDRO). A QDRO is required to be accepted by the plan administrator unless the QDRO requests that the plan assign those assets in a manner or payout methodology that the plan does not provide for.
IRA’s, SEP’s, SIMPLE’s, non-qualified plans and annuities do not have a QDRO requirement. Only plans that are subject to the rules of ERISA require the QDRO. Distributions pursuant to a divorce (QDRO or non-QDRO court ordered ‘assignments) from any plan types are free from the 10% premature distribution penalty; however income tax may apply to all before tax contributions distributed from the plan if not rolled over. The spouse from whose plan the assets are distributed from is not considered to have made a distribution for which they would have to pay income taxes or incur a premature distribution penalty.
CLOSING REMARKS AND A FEW THOUGHTS
An equitable divorce is not one that merely splits total fair market value of assets in half. Rather it should be one that takes into account after tax considerations of all assets in question. Don’t take the $1,000,000 pension account and give the ex the $1,000,000 home that you just paid a $1,000,000 for! The pension is entirely taxable when distributed whereas the home could be sold with no tax liability.
Alimony received is income for purposes of funding an IRA; don’t forget that, especially if you no longer are a beneficiary of the ex-spouse’s ongoing retirement plan contributions and growth and you need to jump start your own retirement plans!
What is separate property versus that which has been accumulated during the union and considered jointly acquired or community property? If we have intentions of insulating from our marital estate those assets that we acquired prior to marriage or were inherited or gifted to us during our marriage, so that they remain ours should a dissolution come about (or a legal claim be made as a result of an ‘act of liability’ of the ‘other’ spouse), seek legal counsel on ways of preserving the independence of those assets from inclusion as consideration of an asset of the marital estate before you get married or when you receive that inheritance or gift so that you can make informed decisions on taking action to achieve your goals and objectives with respect to the rights and or claims to those assets.
I will be back with you next blog with more on property titling and beneficiaries as I promised. Thanks for reading…
David Bergmann, CFP?, EA, CLU, ChFC
The David Bergmann Group
Marina Del Ray, CA