Identifying the Tax Consequences of Divorce Part 4

Cindy Best

10. Capital Gains Taxes and Appreciated Assets

 

The spouse who winds up owning an appreciated asset (fair market value in excess of tax basis) must recognize taxable gain when it is sold. In other words, if you are the one who ends up with appreciated assets like stock or real property, you’re on the hook for the built-in tax liability that comes with them. Thus, from a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that have not appreciated. Here?s an example:

Your divorce settlement calls for your spouse to receive all your long-held Apple shares. Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex keeps on rolling under the same tax rules that would have applied had you continued to own the shares (carryover basis and carryover holding period). When your spouse ultimately sells the shares, he or she (not you) will owe any resulting capital gains taxes.

Capital gains tax implications are very important to consider during divorce, as the difference between net-of-tax value and net value can be significant for many types of assets. Even seemingly minor items like sports memorabilia or antique furniture can trigger capital gains taxes, and equitable dissolution can be significantly thwarted by failure to consider capital gains tax implications.

I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.

 

11. Selling the Marital Home and Capital Gains

 

Sale of the marital home is often the only option if both parties are to receive an equitable share in the distribution of joint assets, but the sale of a house can expose the owners to taxes. Despite the collapse of the housing market, spouses still must consider the capital gains relating to the sale of homes. A couple who bought a house in the early part of the housing boom may face considerable capital gains because the stratospheric prices of the housing market moved the house far above what the couple paid for it. If a person realizes more than $250,000 (if single) or more than $500,000 (if married, filing jointly), the gain will be taxed at 8 percent or 18 percent, depending upon income.

Since 1997, each spouse may exclude up to $250,000 (or $500,000 as a couple) from any capital gains tax if the spouses have lived in the house for any two of the last five years. This capital gains exclusion can work against a single house owner who takes the house as part of the settlement, and then sells it later as a single person for more than $250,000. If the house sells for more than $250,000 more than they paid for it, the owner will owe taxes.

In order for the capital gains tax exclusion to apply the house must have been the principal residence for two of the past five years when it is sold. That means, effectively, that the house must be sold within three years after a spouse departs. It?s common these days in divorce for one of the spouses to move out of the house but to continue to own an interest in it for several years. Once a party is gone for more than three years, the house is no longer the principal residence. If it is sold at gain, taxes will be owed. However, if a spouse moves out and his or her former partner has the right to live in it pursuance to the divorce, that spouse?s residence in the house will be counted for calculating the two year requirement.

In another situation, if a spouse moved out of the house before the divorce was final, and then ended up getting the house in the proceedings anyway, the person can still claim the house as a primary residence.

While the sale of a primary residence can be sheltered from capital gains of up to $500,000, the sale of other real estate may result in taxable events.

Rollover Provision

The rollover provision, which required taxpayers to roll the money from one house to a more expensive house, has been eliminated. Until 1997, a couple who wanted to claim the capital gains tax exclusion on a primary residence had to purchase a new home of equal or greater value than the one they sold. The rollover provision has been eliminated, so a divorcing couple can take the exclusion without buying another home.

I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.

 

12. Spousal Maintenance/ ?IRS Alimony? Recapture

 

When structuring spousal maintenance agreements one should be conscious of the IRS alimony recapture rule (IRS 71(f)). The IRS alimony recapture rule forces the spousal maintenance payer to report as income the spousal maintenance payments previously deducted. If there is a decrease or termination of spousal maintenance (IRS alimony) during the first three calendar years, recapture rules apply if the spousal maintenance (IRS alimony) in the second or third calendar year is $15,000 less than in the prior year. The recapture provision may be initiated by one or more of the following:

  • Failure to make timely payments,
  • Change in divorce or separation agreement,
  • Reduction in spouse support needs, and
  • Reduction in payers ability to provide support

 

For example, if in the first year a payor pays $30,000 in spousal maintenance, then in the second year pays $20,000 in spousal maintenance, but in the third year makes a successful motion to modify the obligation because the payee has a new job and, as a result, only pays $4,000 in spousal maintenance ($16,000 less than the second year), the recapture rule is triggered. The payor must be prepared to report the first year?s and the second year?s formerly deducted spousal maintenance payments as income. And you might have thought you were doing client a favor by petitioning to modify the spousal maintenance obligation in the third year!

However, the recapture rule does not apply:

1) For payments made pursuant to a temporary order;

2) If the payments terminate due to you or your ex?s death;

3) Your ex?s remarriage prior to the end of the third year; and

4) When the total payments made each year vary, for reasons not in your control, and are tied to a business, property, variable employment or self-employment. In these circumstances, the termination and variable amounts of alimony are foreseeable and assumed.

 

The easiest way to avoid the IRS alimony recapture rule is to avoid front loading spousal maintenance agreements. Consider increasing spousal maintenance payments over time, longer schedules of repayment, or tying the payments to uncontrollable income per exemption four above.

 

I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.

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13. Debt forgiveness and ?phantom income?

?Phantom income? is taxable income that the individual never receives as actual income, and it is particularly pertinent in divorce law. When large amounts of debt are at issue in divorce proceedings, often it is the intention of one of the parties to settle the debt for less than the total value presented to the court. It is vital that the concept of phantom income be understood in these situations.

When a debtor settles a debt for less than it?s value, the debtor recieves taxable ?phantom income? equal to the debt forgiven. The creditor essentially “pays” the delinquent borrower the amount of debt forgiven, and creditors send Form 1099-C to the debtor showing the amount of “income” that he or she received as forgiven debt. The debtor then must report this income to the IRS and pay taxes on it.

I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.

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