Your Guide to Taxes and Divorce

Divorce can be an emotionally charged process, but it is also a time when critical financial decisions are made. Among these decisions, the division of assets can have long-lasting financial and tax implications for both spouses. Navigating this complex process with proper planning can help provide a fair outcome for both parties while minimizing unnecessary tax burdens. Below, we explore some essential tax considerations and address the specific implications of one spouse keeping the marital home.

Tax Implications When Dividing Assets

When assets are divided during a divorce, it is vital to consider the tax basis and future tax liabilities associated with each asset. Here are some key points to keep in mind:

1. Taxable vs. Non-Taxable Transfers: Transfers of property between spouses as part of a divorce settlement are generally tax-free under Section 1041 of the Internal Revenue Code. However, once the transfer is complete, any future sales or income the asset generates will be taxable for the receiving spouse. The tax-free provision does not apply to transfers made after the divorce is finalized unless explicitly stated in the settlement agreement.
2. Capital Gains Tax: The tax basis of an asset remains unchanged after transfer. For example, if one spouse receives an asset with significant unrealized capital gains (like stocks or real estate), they may face a hefty capital gains tax when selling it in the future. To plan effectively, both parties should assess the potential tax liability associated with each asset and weigh this against the asset’s current value.
3. Retirement Accounts: Dividing retirement accounts such as 401(k)s or IRAs requires careful planning to avoid penalties and taxes. A Qualified Domestic Relations Order (QDRO) is necessary for splitting certain retirement accounts without triggering taxes. For IRAs, transfers can be made tax-free if stipulated in the divorce decree. However, early withdrawals before age 59½ may incur penalties unless an exception applies. Additionally, a non-participant spouse of a 401(k) has a one-time opportunity to withdraw cash penalty-free regardless of age, as long as the account remains in the participant’s name at the time of withdrawal. This exception allows for immediate liquidity, but should be considered carefully due to the tax implications of the withdrawal being treated as ordinary income.
4. Cash Flow and Taxable Income: Division of assets can affect taxable income. For instance, receiving alimony (taxable under agreements finalized before 2019) or rental income from investment properties can increase a spouse’s tax obligations. Additionally, income-generating assets like dividend-paying stocks or rental properties require an assessment of both their current income potential and future appreciation.
5. Debts and Liabilities: It is not just assets that need to be divided. Liabilities must also be addressed. If one spouse takes on a shared debt, such as a mortgage or credit card balance, they must understand the potential tax implications, including interest deductions or the impact of forgiven debt on taxable income. Both parties should strive for a clear understanding of how debts will be managed post-divorce.

Keeping the Marital Home: Financial and Tax Considerations

The marital home often holds sentimental value, making it a contentious asset during divorce proceedings. However, choosing to keep the home can have significant financial and tax implications.

1. Affordability: The spouse retaining the home must evaluate whether they can afford ongoing costs such as mortgage payments, property taxes, insurance, and maintenance. This is particularly important if their income changes after the divorce. Refinancing the mortgage to remove the other spouse’s name can add additional financial strain, especially if interest rates are higher than when the original mortgage was obtained.
2. Capital Gains Exclusion: When selling a primary residence, individuals may exclude up to $250,000 ($500,000 for married couples) of capital gains from taxable income if they meet ownership and use requirements. If the home is sold post-divorce, the exclusion may be limited to $250,000 for the spouse who retains it, potentially increasing taxable gains. The timing of the sale can impact this exclusion, so spouses should consider whether selling the home during or shortly after the divorce might yield better financial results.
3. Equity Buyout: If one spouse keeps the home, they often buy out the other spouse’s share of the equity. The funds for this buyout could come from other marital assets, savings, or refinancing the mortgage. Refinancing may impact the spouse’s debt-to-income ratio and financial stability. Additionally, the buyout process should account for the home’s fair market value and any existing liabilities, such as liens or unpaid property taxes.
4. Future Value vs. Liquidity: Real estate is an illiquid asset. Retaining the home might seem like a sound choice, but if it’s the primary asset received, the spouse could face cash flow challenges. Balancing liquid and illiquid assets is crucial for post-divorce financial health. In some cases, selling the home and dividing the proceeds may provide both spouses with greater financial flexibility.
5. Emotional Considerations: While financial factors are paramount, emotional attachment to the marital home can influence decision-making. Spouses should carefully weigh whether retaining the home aligns with their long-term financial and personal goals or if it might hinder their ability to rebuild their lives post-divorce.

Strategies for Effective Divorce Financial Planning

1. Engage Professionals: Work with a Certified Divorce Financial Analyst (CDFA®), tax professional or financial planner who understands the intricacies of divorce-related finances. These professionals can help evaluate asset division proposals, analyze tax implications and provide insights into long-term financial planning.
2. Prioritize Long-Term Impact: Consider the long-term financial implications of asset division, not just immediate needs. Ensure an equitable distribution that supports both short-term stability and future financial goals. For example, a spouse who prioritizes keeping the marital home may need to forgo other valuable assets, which could impact their retirement savings.
3. Document Everything: Ensure that all agreements regarding asset division, alimony and other financial arrangements are clearly documented in the divorce decree to avoid misunderstandings and tax complications later. This documentation should include specifics about timing, payment methods and contingencies for unforeseen circumstances.
4. Understand State Laws: Divorce laws vary by state, affecting property division, tax treatment and other financial aspects. Some states follow equitable distribution principles, while others adhere to community property rules. Ensure compliance with your state’s regulations and consult with an attorney to understand how local laws impact your financial settlement.
5. Review and Update Financial Plans: After divorce, both spouses should revisit their financial plans, update account beneficiaries, and adjust investment strategies to align with their new financial realities. This process should include updating wills, trusts, and powers of attorney to reflect changes in family dynamics and financial priorities.

Mitigating Challenges

Divorce is a challenging process, but careful financial planning can help mitigate the stress and uncertainty that often accompany it. Understanding the tax implications of asset division and the specific considerations around keeping the marital home can help divorcing spouses make informed decisions. Work with experienced professionals to make financial agreements equitable, sustainable and aligned with long-term goals. By taking a proactive approach, individuals can navigate divorce more confidently and lay the foundation for a secure financial future.

This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.

Michael J. Goldstein Financial Advisor CFP®, ChFC®, AAMS®, CDFA®

Mike has been involved in the financial services industry since 2001. He is a member of the Lake County (IL) Bar Association and the Lake County Estate Planning Council.