Divorce Settlements: Watch Out For Tax Traps
By Julian Block
The breakup of a marriage forces a couple to deal with many complex financial problems. In negotiating an agreement, the couple's main concerns might be alimony, child custody, and child support arrangements. However, they might also have to deal with dependency exemptions for children (discussed in more detail below), joint liability on joint returns, legal fees (discussed below) and transfers of property.
To add to their troubles, complex tax rules can make it even harder to hammer out an agreement. But unless those rules are carefully considered while the settlement is still in the proposal state, one or the other of the splitting spouses might be in for an unpleasant surprise when it is too late to change anything.
Consider, for example, what happens when there is a transfer of appreciated property in a divorce settlement. At one time, the law, in effect, treated such a transfer in much the same way as if the property had been sold. Here's the background:
Frequently, the splitting spouses negotiate an agreement that requires one mate (usually, the husband) to transfer stock, real estate or other assets to the wife to obtain her release of support rights. It is unlikely that they will see any profit or loss in such a swap. The old law, however, treated the transaction as though he had sold the property for an amount equal to the value of her relinquished support rights, which were considered to be equal to the value of the property transferred.
Assume John and Mary worked out a deal that required the husband-to-wife transfer of stock that cost him $10,000 some years ago and is worth $250,000 in today's market. John had to report a long-term capital gain of $240,000. As for Mary, she did not have to count as income the property received for her release of support rights. For purposes of figuring gain or loss on a later sale, the stock was considered to have cost her $240,000.
But the way the law now works, it is a much different story. John is excused from reporting a gain or loss on a transfer of property to Mary that is "incident to a divorce." This is a property transfer that occurs within one year after they cease to be married or that is related to the divorce.
The current rules apply whether John transfers the stock to Mary for the relinquishment by her of her marital rights, which is what usually happens, for cash or other property, for the assumption by her of some liabilities or for other consideration that she provides. Mary's cost (in tax jargon, her basis) for such property is John's basis ($10,000 in my example). Result: If she then sells the stock for its value of $250,000, the gain of $240,000 is taxed to her.
CAUTION. My example underscores a point to keep in mind when there is a division of appreciated property in a divorce settlement. There might be an overstatement of the $250,000 value assigned to the shares of stock if that value fails to reflect the potential taxes that Mary would incur on the $240,000 appreciation if she subsequently sells her stock. Consequently, it is to Mary's advantage to seek inclusion in the divorce agreement of a provision that requires John to reimburse her for any tax liability triggered upon the sale or other disposition of the stock. Alternatively, Mary could negotiate for a settlement that assigns as the stock's value the amount of estimated after-tax-proceeds that she would receive upon disposing of her shares.
A final thought on a stressful event like divorce that frequently results in painful negotiations: What prompts my suggestions is not that I want to provide tax strategies for Mary to employ against John; rather, all I have in mind is to explain a tricky problem and help both of them to compromise their competing interests.