Negotiating Divorce: Don’t Overlook Taxes, Community Property

During a divorce, major decisions are made about who gets what, when and how. If you haven’t been married long, it is much easier to part ways, especially financially. But for married couples who have built a life together and now have varied and sizeable assets, there are serious financial consequences to divorce.

Houses, investment property, retirement accounts and business assets are usually the major focus of negotiation. It’s critical that you go into the proceedings with a clear picture of your financial situation. Among the issues we talk about with clients negotiating a divorce:

What is community property
Washington State and eight others —  Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Wisconsin –  are community property states. This means that for married residents, all assets acquired during the marriage are considered to be jointly owned. Say that while married you bought a pied-a-terre in Paris with funds you yourself earned and the title is in your name. Yours, right? Wrong. But if you and only you inherited that Paris apartment from an aunt, before or even during the marriage, then it most likely belongs to you only.

Gains from selling the family home
A married couple can exclude up to $500,000 in gains from the sale of a primary residence ($250,000 each if divorced). But you must have owned and used the house as your principal residence for at least two years during the five years before the sale. If the divorce settlement gives you ownership of a home, you can count the time the place was owned by your former spouse as time you owned the house for purposes of passing the 2-out-of-5 years test.

The tax effects of child custody
The parent with custody (has the child most days of the year) generally claims the dependency exemption. Note that starting in 2018, there are no more personal exemptions, worth $4,050 for each tax filer and dependents. What we do have now is a more generous credit of $2,000 for each child under 17. Also worth considering: whether you can qualify for the more tax-advantageous “Head of Household” filing status in any one year. Generally, this means you have provided more than half the cost of keeping a home for a person who could be your dependent.

Retirement account access
If the divorce settlement gives you assets from your spouse’s 401(k), you have the option of specifying in a Qualified Domestic Relations Order (QDRO) how you want to receive those assets. You can take some cash out of the 401(k) without the 10% early withdrawal penalty even if you are younger than 59 ½. The remainder can be rolled into an Individual Retirement Account. The amount you take in cash will be taxed as income, so plan ahead for taxes. Such withdrawals must be outlined in the QDRO and approved by the judge and retirement plan administrator, but this can be a good way to get access to some cash that you can use to transition to the next stage of your life.

IRAs are treated a little differently. If a transfer of IRA funds is specified in the QDRO, this must be done via transfer from one IRA custodian to another. If IRA money is received by one of the ex-spouses, he/she will owe tax on the amount.

Changes to how alimony is taxed
The 2017 Tax Cuts and Job Acts changes how alimony payments are treated. Alimony payments will no longer be tax-deductible for divorces finalized after 2018. However, those who receive the alimony will not be taxed on it. This is the reverse of what used to be the case.

For more on the 2017 Tax Law, read this article by LNWM’s Kristi Mathisen. Or view this webinar by Kristi.

The bottom line: If your assets are varied and sizeable, consult a financial advisor and a tax professional as you make decisions about divorce. At LNWM, we provide both financial and tax strategies in preparation for divorce.

For more, please read my posts on Preparing for Divorce and After a Divorce.