Navigating the complexities of divorce and taxes

With the exception of child custody, the distribution of marital property is arguably the most important aspect of a divorce agreement. When considering division of assets, remember that what looks equitable on the surface may not be. One major reason is tax liability.

Typically, any transfer of marital property to one spouse that occurs as a result of a divorce settlement is not taxable at the time of transfer. However, any taxes due after the sale of assets or income earned from investments after the divorce will be paid solely by the spouse who was awarded the asset.

Let’s take a look at two areas of tax liability that come into play: income taxes and capital gains taxes.

Income Taxes and Divorce

When it comes to alimony, it’s easy to let emotions take over during negotiations. The temptation to “stick it to” a divorcing spouse by getting as much as possible is common, but not always not in your best interest.

Alimony is usually paid monthly directly to the receiving spouse. Payments to a third party, like a former spouse making mortgage payments for you, could also be considered alimony income. Alimony payments are tax-deductible for the paying spouse and fully taxable as regular income to the receiving spouse.

Particularly if you have your own source of income, more is not always better when it comes to alimony. Demanding higher alimony may backfire by pushing you into a higher tax bracket – resulting in a lower take-home portion from all income sources – while providing tax benefits to your former spouse.

Consider how much alimony you actually need. It may be smarter to forgo some immediate spousal support in favor of more deferred income in the form of retirement accounts or investments. A financial neutral, or Certified Divorce Financial Analyst, can help you determine the best solution.

Capital Gains Taxes and Divorce

Capital gains taxes are paid on the sale of an investment, but only on the proceeds over the cost basis, which is the amount paid for the investment. For example, if stock purchased for $10,000 in 2010 was sold today at a value of $50,000, capital gains taxes on the $40,000 appreciation of the stock value would be due.

There are two capital gains categories: short term (investments held under one year), and long term (investments held more than one year). Unless you are in the top income tax bracket, long term capital gains are taxed at a much lower rate than short term capital gains.

When it comes to dividing investments, equal isn’t always equitable. Taxes can make a big impact.

Example 1: Two assets have a current value of $250,000. We will assume both are subject to long term capital gains taxes at 15% if they are sold.

Example 2: Two assets have the same current value and cost basis. The first was purchased in 2007, and the second was purchased 3 months ago. We will assume a 28% short-term capital gains rate.

When negotiating a divorce settlement, keep in mind the asset values listed on brokerage statements don’t tell the full story. Sometimes a higher asset value may be camouflaging a big tax bill coming down the road, and a smaller asset could net you more money in the end. This is another area where a CDFA or financial neutral analyst can help determine what might be in your long term best interest.

To speak with a CDFA, call us at (972) 473-4700