It is important to remember that nearly all divorce decisions have corresponding financial and tax implications that need to be considered. There are many questions that need to be answered. These include:
- Who will get custody of the children?
- Who will stay in the marital home?
- How much support will I have to pay (or am I entitled to receive)?
- Will our assets be split 50/50 or in some other way?
Who Gets the House?
It may be that the spouse who is awarded physical custody of the children will want to keep the house. Often this makes sense: why move the kids into a new environment at the same time they are going through the breakup of the family? There are financial considerations for both the spouse awarded the home and the one who leaves it, however.
As soon as is feasible, the home should be inspected to see if there are any pressing issues that need to be addressed. For example,
- Does the roof need repair or replacement?
- What is the age of the furnace / air conditioning unit and when will it need to be replaced?
- Are the appliances and hot water heater in good working order?
- How much is the mortgage payment each month?
- How much are the monthly bills?
- Can you afford the property taxes?
- What are the annual maintenance costs of the home?
If the couple chooses to sell the home, there are possible tax implications. When selling a primary residence, the Internal Revenue Service (IRS) allows for an exemption on the profits of the sale, but there are limitations. For instance, to claim the exemption, one must meet ownership and use tests. In the five years prior to the sale:
- The home must have been owned for at least two years
- The home must have been the primary residence for at least two years
The ownership and use tests are particularly important to keep in mind if you are the spouse that is NOT going to keep the home. If you are entitled to half of the proceeds upon sale, and the sale is not for a few years into the future, than you will NOT be able to exclude the income from your income tax returns.
There are also limits to the amount of gain that can be excluded from taxes if the house has appreciated in value. If, after the divorce, the house is sold, the spouse who sells the home will be able to exclude up to $250,000, but if the house is sold prior to the divorce being finalized, the couple can receive the higher exclusion of $500,000. To avoid capital gains taxes on the income, this money must be reinvested within two years of the sale of the home.
Other costs associated with the sale include transfer taxes, loan closing fees, realtor commissions and more. If the sale is made after the divorce is finalized, the spouse that sells the house will be responsible for these costs — if the sale is made prior to the divorce, than the costs will be split between the spouses. So, it may be in the best financial interests of the divorcing spouses to sell the home prior to the divorce.
While the example given only includes the marital home, there are financial and tax consideration for all types of property. These should all be considered and planned for.
Other Financial Considerations
Receiving alimony — also known as spousal support — may help the lower-income spouse maintain an accustomed standard of living or make financial ends meet. Tax implications must be considered before any award of alimony. The spouse that receives alimony must treat this money as income and pay taxes on the support that is received. For the spouse that pays alimony, this money is tax deductible. The payments to be made must be budgeted for and considered when making other financial decisions.
Child support, on the other hand, typically has no effect on the taxable income of either spouse.
Capital Gains on the Sale of Stock
If a divorcing couple decides to sell stock in order to split it 50/50, it should be remembered that capital gains tax must be paid on the appreciated value. The same is true if one spouse buys the other spouse’s shares and later sells them. In this case, the spouse whose shares were purchased may avoid paying capital gains taxes. The tax implications of stock purchases and sales should always be considered when dividing assets.
Marital debt is divided between the spouses. If you and your spouse have a heavy debt load, plan to receive around half of it in the event of a divorce. In some instances, it may be beneficial for the divorcing couple to consult with a bankruptcy attorney before the divorce is finalized.
Splitting a retirement plan may require the drafting of a Qualified Domestic Relations Order (QDRO). A QDRO provides the ex-spouse the same distribution of funds that he or she would have had the marriage not ended. If you are splitting an IRA, the IRA can be transferred tax-free to a new IRA. If this is not done right away, you may be subject to an IRS withholding penalty.
Even splitting assets 50/50 doesn’t always result in a 50/50 split. Taxes, upkeep, repair, replacement and other costs all need to be considered. Plan accordingly by developing a budget, obtaining accurate property valuations, and speaking with an experienced divorce attorney who is well versed in the financial implications of a divorce. The advice of a certified financial planner can also be invaluable prior to or during a divorce proceeding.