Many divorce attorneys overlook tax issues—much to their clients’ detriment. Whenever a piece of property is sold, the owner typically needs to pay capital gains tax. Fortunately, federal tax law makes an important exception when it comes to divorce, but this does not mean that spouses will avoid having to pay taxes. Instead, tax might be paid later, and the amount could dramatically reduce the value of the asset.
At Lawrence Law Office, we make tax planning central to every divorce. We fully analyze how the transfer and disposition of certain property will affect our clients and come up with a divorce strategy that maximizes our clients’ post-divorce finances. Without this consideration, our clients could end up worse off, even when marital property is split 50/50.
For help thinking through tax issues, please contact our law firm today.
General Rule: No Tax for Transfers between Spouses
As a general rule, Internal Revenue Code section 1041 states that transfers of property between spouses incident to a divorce are not subject to taxation. Instead, the transfers are treated like gifts. The person receiving the property (transferee) takes the tax basis of the person who transferred it (transferor).
This rule applies to all transfers between spouses. When made incident to divorce, the transfer falls under this rule if it is made within one year of the date when marriage ceases or is related to the cessation of the marriage. Generally, if a transfer is made under a divorce or separation agreement and is made within 6 years of the cessation of marriage, it will qualify for tax-exempt status.
The timing of the transfer can sometimes be unclear, so it is important to work with an experienced attorney. In part, the date of transfer depends on when the transferee spouse takes physical possession of the asset.
No Step Up Basis
Capital gains tax is typically due when the transferee sells the asset. Calculating the amount of taxes owed, however, requires understanding the tax basis.
If you inherited your mother’s house, then the capital gains tax is calculated on a step-up basis. This is the value of the home at the time that you inherited it—not the value when your mother bought it. The capital gains tax is paid on the difference between the value when you inherited it and what you sold it for.
However, section 1041 states that the transferee will get a carryover basis, not a step-up basis. This means that the transferee spouse who ultimately sells the asset could be responsible for a significant tax bill. For example, the spouse might take the home which was bought in 2000 for $120,000. It might now be worth $300,000. This equates to a hefty tax bill.
When dividing marital property, we are always aware of how much our client would have to pay if and when she sells the home. If tax issues like these are not accounted for, then the spouse who takes the property could have unexpected tax liability and end up worse off under the property settlement agreement.
Shift Property to the Spouse with a Lower Marginal Tax Rate
The amount of capital gains tax paid will also depend on each spouse’s marginal tax rate at the time they dispose of the asset. Careful planning can reduce the tax burden—and increase the value of the marital estate—when assets with large built-in gains are shifted to the spouse with the lower marginal tax rate.
Not all property has large built-in gains, however, so an attorney must carefully review every piece of marital property to determine its true value. For example, the couple might have only recently obtained real estate, which means that the built-in gains could be insignificant. These types of assets could more sensibly go to the spouse with a higher marginal tax rate.
Issues with a Nonresident Alien Spouse
If one spouse is a non-resident alien, then the general rule discussed above does not apply. Taxes will be due on the date of the transfer. The reasoning is that the nonresident alien probably will not pay U.S. taxes in the future, so the IRS has little chance of eventually getting any money.
Worried about Taxes? Contact Us
Couples who have amassed significant assets while married must think through all of the tax implications, otherwise the value of the marital estate could be dramatically reduced. The above are only some of the more obvious; there are many more.
At Lawrence Law Office, our team is well versed in federal and state tax law. Call us to schedule an initial consultation.