Divorce and Taxes: Issue #4. Property Transfers

In any divorce where the parties own assets of value, there will likely be some transfer of assets between the parties as part of the divorce settlement. Assets that could be at issue range from tangible personal property (i.e. the pots and pans) to bank, investment and retirement accounts. In addition, the most valuable asset in many marriages is the marital home (and/or other real property). Although generally tax implications in spousal transfers are minimal there are some issues to look out for.

Issue #4. PROPERTY TRANSFERS: Because some assets are post-tax (such as bank accounts) and some assets are pre-tax (such as retirement accounts or capital gains), it is important to understand the tax implications in dividing them. If you trade a pre-tax asset for a post-tax asset of equal value without taking into account the resulting tax liability then you've lost the value of the tax liability. Therefore it is important to understand which assets have tax liability associated with them and whether there are any tax liabilities created through transfer.

PERSONAL PROPERTY WITHOUT CAPITAL GAINS: The transfer of personal property and bank accounts is simple. These items do not typically have any tax basis or capital gains upon transfer or sale because their value is either minor, depreciated, or, in the case of bank accounts, the appreciation is minimal.

PERSONAL PROPERTY WITH CAPITAL GAINS: Similarly, the transfer of property assets with capital gains implications is relatively simple. Pursuant to § 1041(a) of the Internal Revenue Code transfers to a spouse do not result in a gain or loss. This is also true for transfers to a former spouse if the transfer is incident to a divorce. This means that a stock transfered to a spouse or former spouse will maintain the same capital gains characteristics (and tax liabilities) as it would have had in the original spouse's possession. This is also true for an investment account, collectible, or house.

RESIDENTIAL REAL PROPERTY: In the case of residential real property there is a potential benefit to selling the house while still married instead of transferring it between spouses. There is a capital gains exclusion for profits realized on the sale of a residence and it is doubled for spouses. If the parties divorce and one party transfers their interest to the other, and that former spouse then later sells their interest in the residence they will only have the single capital gains exclusion. Of course, this only matters if there is significant equity in the residence.

RETIREMENT ACCOUNTS: Retirement accounts are not typically transferable between anyone, even spouses, without tax consequences. In order to transfer funds held in a retirement account the owner must first remove them from the retirement account, which, if allowed by the rules of the plan, will result in taxable income and, prior to retirement age, tax penalties. However, in the event of a divorce the IRS allows a one-time transfer by Qualified Domestic Relations Order (also known as a "QDRO"). A transfer of retirement account between former spouses pursuant to a QDRO results in a new retirement account held in the name of the other spouse in the amounts and per the terms specified in the QDRO. The retirement income paid from said account will be taxable income upon receipt just as it would have been to the original owner.

Click here to read Divorce and Taxes: Issue #5. Joint Tax Liability.

Divorce and Taxes: Issue #5. Joint Tax Liability

Issues 1 through 4 all focus on the tax liabilities created post-divorce. But what about tax liability incurred during the marriage?

Issue #5. JOINT TAX LIABILITY: The Court has the power in a divorce case to assign both assets and liabilities, including tax liability incurred during the marriage. If there are joint tax returns filed during the marriage for which taxes are still owed, that liability is owed by both parties to the taxing authorities. The Court may assign that debt to one party by order or agreement, but that doesn't always satisfy the taxing authorities.

Unless you file an innocent spouse application with the IRS (and the IRS makes an innocent spouse determination in your favor), they will still consider a joint debt owed by both parties until satisfied. A probate court order allows you to collect against your former spouse but does not prevent the IRS from collecting against you. Therefore, if there are any assets available for the payment of tax debt at the time of divorce, paying the debt off immediately is recommended.

We also recommend including language in any settlement agreement to deal with the possibility of an audit that assigns debt on a joint return that was previously considered satisfied:

"For the years of the marriage (__________ to __________), if there is a deficiency assessed in connection with any joint federal or state income tax returns heretofore or hereafter filed, or if any other notice is received by either Party relating to any Federal or State tax, interest or penalty claim, the Party notified thereof shall forthwith notify the other Party immediately in writing. Each Party, on account of whose net income a deficiency is assessed, shall pay the amount ultimately determined to be due thereon with respect to his or her net income, together with interest and penalties, and shall pay as well any and all expenses that may be incurred if he or she shall decide to contest the assessment.

In the event that the deficiency is assessed with respect to joint income, each shall pay the deficiencies and expenses in the same proportion as each Party actually received the said gross income for the calendar year in which the deficiencies and expenses are assessed. For purposes of this EXHIBIT “gross income” shall be defined in accordance with the applicable provisions of the Internal Revenue Code of 1986 and in accordance with the applicable provisions of the Massachusetts Child Support Guidelines.

Each Party shall keep the other fully informed of any and all steps taken by him or her with respect to any deficiency assessment. The Party whose actions are responsible for the deficiency, if any, shall in all respects indemnify the other against and hold him or her harmless from any deficiency assessment or tax lien arising out of any joint return heretofore or hereafter filed by the Parties, as well as any damages and expenses whatsoever made in connection therewith including reasonable attorney's fees and costs."

Click here to read Divorce and Taxes: Issue #6. Same Sex Marriages.