I am always surprised at the number of times that I see divorce settlements, even those written by legal professionals, which fail to contain any tax provisions. Despite this lack of attention, tax issues can often have the greatest impact on the settlement. Divorcing couples need to look at the tax consequences of their settlement from a broader perspective to understand its long-term effect on the family's financial future.
As I inform all my clients who begin mediation, you should approach taxation issues with the goal of preserving as much of the marital estate as possible. Not only for distributing assets at the time of settlement, but also for future financial planning for the family.
And why not? The more taxes you save, the more you will have left to divide in the end. With more income and assets heading into divorce, you will both be more financially stable in separate households and also be better able to adequately support your children (if children are involved) after the divorce. It's all good for everyone.
Make sure you have a professional who can first educate you on the potential tax issues and pitfalls and the impact they might have on your marital estate before you negotiate the rest of your divorce settlement. Often times, clients need more in depth analysis and actual tax advice than I am not able to provide in mediation since I am not a tax professional. However, I am often able to offer some solid tax guidance and perspective, as well as use some tax planning software designed for divorcing families due to my many years of experience with these issues in private divorce attorney representation.
The 6 tax issues that I've found are most critical to ensure a fair, forward-thinking divorce settlement.
Like many divorcing couples, you may not have considered that beginning in Year 1 of the divorce, you can no longer file "Married Filing Jointly." While this may have minimized your tax burden in the past, you could lose some of these benefits upon divorce. Your individual tax liability might increase in two separate households for several possible reasons:
We often use tax planning software to give our clients a snapshot of how their respective tax pictures will change in Year 1 of divorce. This is not tax advice, of course, but just an estimated report. We use current tax rates, assuming they will continue with the same incomes and applying all other terms and factors of their divorce.
This report gives our clients an excellent view of what they might each expect tax-wise in Year 1 of divorce, and also how much after-tax monthly cash they will have in their budget to live. Some spouses discover they will have to either adjust their W-4 at work to withhold more taxes, or put aside more quarterly taxes if they are self-employed, if the divorce will result in a significantly higher tax rate for them on their individual tax return.
Although often hotly contested in court, this issue is usually resolved easily in mediation. Again, through the use of our tax planning software, I will run different scenarios, both with either spouse taking the deduction(s), or splitting the deduction(s). The reports will show where the greatest tax savings lie. If possible, I want both spouses to realize a tax savings from claiming the children. I also do not want this deduction to result in a wasted tax benefit to anyone.
A spouse with primary custody of the children is entitled by law to claim all of the children in his/her custody. However, there are times that I see this deduction getting wasted on the primary custodian if they have little or no income resulting in any tax liability. The reoccurring theme here is: what is the long-term benefit?
Once again, a key tax aspect to a divorce, but something that most spouses overlook. Being able to take these deductions on the marital home was a given during the marriage. However, upon the divorce, what happens to them? The answer depends on what happens to the marital home. Who assumes the marital home in the settlement, or is the home being sold?
Usually, if one spouse buys the other out of the marital home, they will also have the benefit of keeping these tax shelters moving forward. This is a benefit that the other spouse may lose upon giving up the home, if they cannot afford to purchase another home. Typically, the spouse in this position will negotiate other aspects of the settlement to account for the loss of this benefit.
If you decide to sell the marital home, there are a few tax issues to consider depending on your circumstances leading up to the sale.
Under the Tax Cuts and Jobs Act of 2017, all alimony being paid upon a divorce that is finalized after January 1, 2019 is no longer considered taxable income to the receiving spouse and likewise the paying spouse is no longer able to deduct these payments and receive a tax savings. Formerly, alimony was considered taxable to the recipient and tax deductible to the payer, unless spouses agreed otherwise in their divorce settlement. This new law potentially places the receiving spouse in a much more favorable tax position than ever before. It also further taxes the paying spouse in that their alimony payments are already being made with post-tax dollars (in most cases) and they have lost any tax savings from deducting the payments to help them offset those taxes they already paid on the payments.
As spouses evaluate all the property in the marital estate, the mediator will help them to characterize it, asset by asset. In other words, what are the liquid cash assets versus what are the non-liquid retirement and non-retirement investment assets?
Many non-liquid assets have tax and penalty consequences upon a transfer in a divorce.
The rules and consequences of a transfer are sometimes complex, requiring a solid understanding by the mediator as to how they work specifically related to a divorce. Although some funds can be transferred tax and penalty-free with a certified divorce decree, others will require what is called a Qualified Domestic Relations Order in order for the transfer to be both tax and penalty-free.
Additionally, if you or your spouse need to borrow or take a distribution from a non-liquid asset, there is often a tax and/or penalty consequence. We can analyze and estimate the dollar value of the tax and/or penalty amount upon the distribution, and from that, help you negotiate how you will split any tax or penalty consequence that one or both will face.
Spouses may buy out each others' equity interests in the marital home or of a business as part of their divorce settlement. Often times, when buyouts occur, the spouse who buys out the other does not have a sufficient amount of cash on hand to execute the buyout. In this case, spouses will enter into an installment note agreement for one spouse to pay the other over a period of time after the divorce.
This type of arrangement can be very useful in allowing spouses to move on and finalize their divorce, even if the buyout obligation is not paid in full. The key here is the agreement must specify that the buyout is for property in equitable distribution that is "incident to a divorce." If such is the case, then the transfer is considered tax-free in most cases per IRS Section 1041. However, the payment, in order to be considered a payment "incident to a divorce," must be paid in full within six (6) years after the date of the divorce decree.
Cris Pastore, Esq. is co-founder and managing attorney-mediator at Main Line Family Law Center, a divorce mediation firm with seven offices along the Main Line and Center City, Philadelphia. A practicing attorney for over 20 years, Cris has focused exclusively on divorce mediation since 2007, when he grew increasingly frustrated by destructive nature of the court-contested divorce process. Cris has made it his personal mission to revolutionize this area of practice to preserve family relationships and help families emerge healthy and whole. Follow Cris at @healthy_divorce.
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