James R. Balmforth: Divorce and Estate Planning

Divorce has become an everyday reality in the United States. If you’re planning to get a divorce, you should pay close attention to your short and long-term tax exposure before you divide marital assets. Read on to learn about the effects a divorce can have on your tax liability and estate plans.

Transfer of Assets Between Spouses

The IRS generally doesn’t consider the transfer of assets between divorcing spouses a taxable event. As long as you can demonstrate that divorce was the reason for the asset transfer, you can transfer cash and assets between you and your divorcing spouse tax free.

If you and your spouse have accumulated assets such as mutual funds, stocks, bonds, or artwork, you can be subject to a large capital gains tax bill when you attempt to divide them. For example, when you buy stock shares from your spouse the cost of that stock (for you) has risen. However, you will still be taxed based on the capital gain earned between the time you and your spouse purchased the stock at the original price and when you sell. Meanwhile, your ex-spouse does not need to pay taxes on the money you paid to buy the stock from him or her.

Sale of the Home

For most couples, their home is their most valuable jointly-owned asset. Typically, upon divorce you have three options:

Sell the home and split the proceeds immediately.
Sell the home and split the proceeds sometime in the future.
Allow one spouse to buy out the other’s interest in the property.

You can avoid paying capital gains taxes on the profits from your home sale if you reinvest the home sale proceeds within two years after the sale of your home. The home must be your principal residence, meaning you have lived in the home at least three years out of the last five. Divorced spouses can have a difficult time meeting this requirement when the divorce settlement allows one spouse to remain in the home for more than two years before it is sold. The ex-spouse not residing in the home can lose his or her eligibility to avoid the capital gains tax.

Retirement Funds

Retirement funds can be treated as marital property during a divorce settlement, so you may have to share retirement funds with your spouse. If your spouse has a right to a portion of your retirement funds, you must adhere to the applicable tax laws when you make distributions. You are not allowed to “alienate” or “assign” your qualified pension plan distributions to anyone else.

Qualified Domestic Relations Orders (QDROs)

If you have retirement funds you must share with your spouse upon divorce, it is highly advisable that you obtain a QDRO. A QDRO is a court order detailing the proper procedure for distribution of your retirement benefits in the future. The QDRO allows your benefits plan administrator to proceed with distributions as if you are still married to your ex-spouse, ensuring that neither spouse fails to receive his or her rightful benefits. The QDRO also resolves any issues that may arise if you or your ex-spouse remarry – current and ex-spouses each receive a proportionate share of the plan distributions.

Individual Retirement Accounts (IRAs)

Upon divorce, IRAs are generally considered the sole property of the original owner. However, if you make contributions to your IRA from your earnings during the course of your marriage, your spouse will be entitled to a proportionate amount of IRA assets. The exact distribution amount is subject to state laws.

IRA funds can be transferred tax-free from one spouse to another by a written divorce decree, but if you are the recipient of IRA funds you can be held responsible for a 20 percent federal income tax unless you ask your IRA trustee to roll the transferred funds into your own IRA.

Income Taxes

For married couples, filing separate tax returns is incredibly costly, so if you and your spouse can agree to continue to file jointly until the divorce is final, you will save yourself a lot of money. However, be cautious because if your spouse incurs tax liabilities and penalties, you will be jointly liable.

Dependency Exemption for Children

Unless there’s a court decree stipulating otherwise, the custodial parent is entitled to the dependency exemption. However, the custodial parent can release the exemption by filing IRS Form 8332. Only the custodial parent may take the child care credit, but both parents may able to deduct medical expenses, regardless of custody.

Your Estate Plan

In some states, statutes provide for automatic revocation of any estate plan provisions that mention your former spouse. Be sure to check the applicable laws in your state and make any necessary changes or you may find yourself unintentionally leaving property and assets to your former spouse or call our office for your free consultation.