Making Tax-Smart Property Transfers In A Divorce

There is a third party involved in all divorces: the taxman. Depending on how property is transferred, the taxman could take a gigantic bite out of an asset, dramatically reducing the amount that either spouse takes with them after obtaining their divorce decree.

At Lawrence Law Office, we work closely with CPAs and other tax professionals to fully identify how the tax code will affect our clients. We can then plan property transfers in such a way to use the tax code to our clients’ benefit. Contact us today to learn more.

General Rule: Divorce Property Transfers are Tax-Free

Many transfers trigger taxes. However, 26 U.S. Code § 1041 states that transfers between spouses or incident to divorce are tax-free, which is excellent news. If you are transferring assets while married or as part of the divorce decree, then there are no taxes owed. As a result, couples do not have to waste time worrying about the tax implications of many transfers that they make between themselves.

There are certain rules regarding timing, however. If the transfer is made between spouses within one year of divorce, then the IRS presumes the transfer is made “incident to divorce,” so no income or gift taxes are owed. The clock starts ticking on the date of divorce.

What happens if the transfer happens outside the one-year deadline? In this situation, the transfer must be made “pursuant” to the divorce decree. If it is, then no taxes are owed on the transfer.

However, if more than six years have passed since the divorce, then the IRS presumes that the transfer was unrelated to the divorce. This means that the transfer might be taxed. We will need to overcome this presumption by showing that there was a legitimate reason for the delay in the transfer.

Transfers To Third Parties

The analysis is more complicated if one spouse is transferring property to a third party, such as a corporation. In that situation, you will want the transfer included in the divorce decree and made pursuant to a written request. However, an attorney must analyze this type of transaction very carefully. Ideally, third-party transfers should be avoided, if possible.

Gift Taxes and Transfers

When transfers are made during the marriage, gift taxes are rarely owed because there is an unlimited gift tax deduction. However, when a property transfer is made related to a divorce, then the transfer might be taxed.

There are several situations where the gift is treated as non-taxable:

  • A court issues an order that requires the transfer
  • The transfer is made according to a written settlement agreement if made up to one year before the execution of the agreement or up to two years after
  • The transfer is a direct payment for medical or educational expenses
  • The annual gift tax exclusion covers the transfer
  • The lifetime gift tax exclusion covers the transfer

Capital Gains Taxes

A spouse who takes assets in a divorce could still pay taxes when they sell them. For example, John and Melissa might divorce, with Melissa receiving a vacation property. The couple bought the property for $150,000 in 1988. Today, it is worth $500,000.

Under the tax code, Melissa would get the property on a carryover basis, not a step-up basis. Consequently, she will owe taxes on the $350,000 that she realizes if she sells the real estate for the $500,000 market value.

The capital gains tax rate depends on several factors, such as how long the asset was held and the seller’s income tax bracket. Generally, the higher a person’s income, the higher their possible capital gains tax rate.

If ex-spouses have similar incomes following divorce, it might not matter who takes the property. But if Melissa has a very high income, and her ex-husband John had a very low income, then Melissa could be paying a very high capital gains tax bill when she sells the asset.

There is also a capital gains tax exclusion for when principal residences are sold–$250,000 for a single taxpayer and $500,000 for a married couple. This significant disparity can influence when to sell the home and who should receive it.

Work With A Professional Divorce Lawyer

The division of marital property can be difficult in even short-lived marriages. The process becomes much more complex when we consider tax issues. At Lawrence Law Office, we will do everything possible to ensure that our clients leave their marriage with as much property as possible. This process includes full consideration of how taxes will affect them—now and years down the road.