There is nothing easy about divorce, and it might be impossible to avoid at least some financial turmoil. While figuring out your taxes may be the last thing you want to do in the midst of a divorce, tax planning is something that you shouldn’t overlook. The decisions you make during a divorce can have long-term implications on your tax liability and the financial future of you and your children. Going into the settlement informed and prepared will help you avoid unnecessary stress and conflict.
Tax Considerations During a Divorce Settlement
Consider all Tax Implications
The first step before making any decisions is to consider the tax consequences for each choice. For example, if you decide to sell your assets and split the profits, that could trigger significant capital gains taxes. If you will make or receive child support payments, know they are not tax deductible. However, spousal support payments are subject to income tax, depending on the state you live in. Knowing the tax implications for each choice will help you make the best financial decisions.
The Impact of Filing Status on Your Tax Liability
Spouses in the midst of a divorce settlement have the option of filing their taxes jointly or separately, and each option has its pros and cons. Filing jointly may be preferable if there is a significant disparity between incomes. In many cases, it can result in a lower tax burden for both spouses.
Filing separately may allow both spouses to claim deductions that have the potential to reduce their overall tax burden. Taxes owed by each spouse are based on their own income, deductions, and credits.
Don’t Forget About the Long-Term Tax Consequences of Your Decisions
It’s important that you not only consider the immediate impact of your decisions on your tax liability, but also look at the tax burden you may have down the road. For example, if you receive an asset like a home or stocks as a part of the divorce settlement, and that asset has a low-cost basis, you could be exposed to a very large capital gains tax liability when you sell the asset in the future.
Do You Owe Taxes if You Buy Out Your Ex?
Many experts advise that divorcees treat the settlement like a business negotiation when possible. Just like business partners buying each other out, the divorcing parties can exchange assets for cash, or sell them for cash and split the profits. However, this can leave one or both spouses exposed to large capital gains taxes.
In most states, the exchange and distribution of assets during a divorce is considered a gift for tax reasons. It is not taxable as long as it is made during the divorce proceedings or in the years immediately following as a part of the settlement. That means that neither spouse will owe taxes on the immediate exchange of assets. However, the real problem comes when you try to sell that asset further down the line.
If you decide to sell your asset outright, those profits are subject to capital gains taxes. Depending on how much your asset has appreciated, those taxes can be significant.
Capital Gains Tax Liabilities in Various Scenarios
Property
Let’s say that you and your spouse own a vacation home that you bought together for $500,000 and it is now worth $3 million. You could buy the house from your spouse for $500,000 as a part of the divorce proceedings, and you would not owe capital gains taxes on the exchange. Your spouse also would be released from tax liability on that home, and would not owe taxes now or in the future.
However, let’s say that a few years from now you decide to sell the vacation home for $3 million. You would owe capital gains taxes on the $2.5 million profit on that home. Because it is a vacation home, you aren’t eligible for the primary residence exclusion either. Depending on the state you live in, you will owe upwards of $500,000 in capital gains taxes. In California, you could owe more than $825,000.
Liquid Assets
If you and your spouse have an investment portfolio or other liquid assets, the tax consequences are similarly sharp. Let’s imagine that you and your spouse purchased $100,000 worth of stocks earlier in your marriage, and over the years they appreciated so that they are now worth $500,000. The divorce settlement requires that your spouse relinquish his or her half of the shares to you for $250,000. This exchange is tax-free as a part of the divorce proceedings.
Now let’s imagine that you hold onto those stocks for ten more years and you eventually decide to sell them for $1.5 million. Capital gains taxes will be assessed on the full appreciation from the purchase price of $100,000. At a 20% capital gains tax rate that would cost you $280,000.
How a Deferred Sales Trust Can Provide Capital Gains Tax Relief
A Deferred Sales Trust (or DST) is a tax strategy where you use the money from the sale of almost any asset to establish an independent, third-party, business trust. A certified Deferred Sales Trust trustee will give you a promissory note in exchange for your asset, outlining the terms of repayment. You have the ability to reinvest 100% of the profits from your asset as long as those proceeds remain in the trust.
Under the terms of the IRS tax code, this falls under the rules regulating an “installment sale.” As long as the principal proceeds remain in the trust, you have not taken constructive receipt of the funds, allowing you to defer the capital gains taxes owed. If you structure the trust to make interest-only payments to you, you will only owe income tax on the interest received. However, if the payments include both interest and principal, you will owe capital gains tax on the portion of the principal received.
Thus, a Deferred Sales Trust would allow a divorcing spouse to defer capital gains taxes on real estate. In our previous example, we imagined that you and your spouse owned a vacation home you previously purchased for $500,000 that is now worth $3 million. Instead of selling the property for $3 million and realizing $2.5 million in capital gains, you could utilize a DST.
With your proceeds in a tax deferred trust, you are free to reinvest all of your money, or receive your proceeds in regular installments over time. You won’t owe any taxes until you receive a payment. By spreading the payments out over time you save yourself from a large lump-sum tax payment, and you maximize the amount of money you have to reinvest. Another option is structuring the promissory note to payout interest-only payments keeping all thel capital gains tax in a deferral state. You will only owe income tax on the interest-only payments received.
Using a Deferred Sales Trust as a part of divorce tax planning is a wise financial move in a challenging scenario. It can pave the way for a more secure financial future for you and your family.