In two recent posts we looked at some aspects of income tax filing for newly separated or divorced individuals, and specifically some of the tax implications of support payments, including child support and spousal support. Today we are going to look at some of the tax implications of dividing marital property in divorce. Understanding tax treatment of property transfers is not only important for filing taxes correctly, it can also help with decision-making. For example, you may want to reconsider buying out your spouse’s share of the family home if you think it will leave you with a high tax liability down the road.
Tax Implications of Property Transfers
Selling property like real estate or stock shares normally results in the seller paying capital gains tax on any appreciation in value. The taxable amount is the difference between the sale price of the property and its original or adjusted purchase price. In the case of real estate, the original purchase price can be adjusted by adding the cost of home improvements. The purchase price or adjusted purchase price is the property’s “basis,” and any gain to the seller over the basis is taxable. If one spouse transfers appreciated property to the other during divorce, however, the transfer is not considered a sale, and there is no taxable gain. So, for example, if a married couple purchased a home together for $150,000 and invested $50,000 on improving the home during the marriage, the basis of the property would be $200,000. If the home is worth $400,000 when the couple decides to divorce, one spouse could “buy out” the other’s $200,000 share of the property (or whatever the home equity value would be after the mortgage payoff) without either spouse paying taxes on the $200,000 increase in value over the basis.
Property owners must be aware, however, that this type of transfer is not really tax free; it is simply tax-deferred. Normally, the purchaser of an asset will use the new purchase price as the basis for calculation of any gain when selling that asset. So, in the previous scenario, if a third party bought the home from the couple for $400,000, the purchaser’s new basis would be $400,000. If one spouse keeps the property however, the basis would remain at $200,000. If the house in our example is sold again for $600,000 a few years after the divorce, the third party purchaser would have a capital gain of $200,000, but the divorced spouse would have a capital gain of $400,000.
Under current IRS rules, capital gains are rarely a concern for homeowners unless property has appreciated substantially in value, because a certain amount of gain can be excluded from taxes, provided that the owner has lived in the home as a primary residence for at least two of the last five years prior to sale. The exclusion will be much lower, however, for a divorced spouse who continues to own the property as a newly single individual. A married couple can exclude up to $500,000 of capital gain on a sale, while a single or head of household taxpayer can exclude only $250,000.
In our example above, the now single former spouse selling the property for $600,000 would pay capital gains tax on $600,000, minus the $200,000 basis, minus the $250,000 capital gains exclusion, and minus certain costs of sale (or a net of $150,000 minus costs of sale). If instead the couple had sold the house for $400,000 while still married, they would have paid no tax on the sale, because $600,000 minus the $200,000 basis minus the $500,000 married persons exclusion is less than zero. They would also pay no tax if they continued to own it together after the divorce and then sold it for $600,000 a few years later, as long as at least one of them had lived in it for the appropriate amount of time, because each of them could then exclude up to $250,000 of the $400,000 taxable gain. A third party buyer using the home as a principal residence and then selling it for $600,000 would also pay no capital gains tax, regardless of marital status, because the capital gain would be only $200,000 ($600,000 minus the new basis of $400,000), which is below the allowance for even a single taxpayer.
The same analysis applies to other assets that will have taxable appreciation if sold or cashed out, except that for these other assets, there will be no capital gains exclusion. The entire difference between the original basis and the ultimate sales price will be taxable at the capital gains rate. An awareness and consideration of these potential tax consequences is important when comparing the value of one marital asset to another asset or to cash.
Dividing or Withdrawing Retirement Assets
Retirement assets usually consist of ordinary income that has been put aside by an individual or an employer on a tax-deferred basis for withdrawal during retirement. Withdrawing funds early (before age 59 ½) can trigger a 10% tax penalty. In some cases, withdrawals are tax-free because contributions were made with after-tax income. Calculating the current cash value of a retirement asset requires consideration of future tax liability. (For pensions or similar defined benefit plans, valuation is even more complex and may require an actuary’s assistance.)
A properly executed transfer of a retirement asset from one spouse to another during divorce is not taxable. The recipient spouse, however, would have to pay ordinary income tax on any funds withdrawn after transfer, unless the contributions were made with after-tax income. If one spouse transfers all or part of a defined contribution retirement account (such as a 401k) to the other by means of a QDRO as part of a divorce, the recipient spouse can withdraw funds as an “alternate payee” without paying the additional 10% tax penalty even if the spouse is not yet 59 ½ years old. This is not the case, however, for other retirement accounts such as IRA’s. Because there are so many different types of retirement accounts, and because transferring retirement accounts in divorce is so complex, attorney assistance is essential to avoid costly errors.
You can find more information about the tax consequence of transferring property during divorce in IRS Publication 504, Divorced or Separated Individuals. For help with your individual tax situations, consult with an accountant.
To speak with an attorneys for assistance with a QDRO, or with other aspects of marital property distribution during divorce, contact Weinberger Divorce & Family Law Group for a free consultation.