With the exception of child custody, the distribution of marital assets can be the most emotional element of a divorce settlement. When considering division of assets, it’s important to keep your wits about you and dive into the details. What looks equitable on the surface may in truth not be equitable at all––especially when you factor in tax liability.
In a divorce settlement, any transfer of marital property from one spouse to another is typically not taxable at the time of the transfer. However, this changes after the divorce is finalized. From that point forward any taxes or penalties incurred from the sale of—or income earned from—investments are solely the responsibility of the spouse holding the asset.
Let’s examine two areas of tax liability: income taxes and capital gains taxes.
Tax Traps Haunting Income Streams
When negotiating an alimony agreement, it’s easy to be overtaken by the temptation to “stick it ” to a divorcing spouse by getting as much monthly income from them as possible. But this is often not the best settlement strategy.
Alimony is any financial support paid directly to an ex-spouse for living expenses, or for reimbursement for financial obligations such as a mortgage payment. While alimony is tax-deductible for the spouse making the payment, it is fully taxable as regular income for the receiving spouse.
Thus, “more” is not always beneficial when it comes to alimony— particularly if the receiving spouse has his or her own source of income. Why? Higher alimony payments may push the receiving spouse into a higher tax bracket. This means less income from all sources for the receiving spouse while the paying spouse can realize significant tax benefits.
Before reaching this decision, consider how much alimony support you actually need. It may be more beneficial to forego some spousal support in favor of a greater share of the marital investment portfolio from investments such as retirement accounts. A financial expert such as a Certified Divorce Financial Analyst can help you determine which strategy is in your best long-term interests.
Capital Gains Hazards
Capital gains taxes are paid on the proceeds (profits) from the sale of assets. For example, if stocks purchased for $10,000 in 2010 were sold in the current taxable year for $50,000, capital gains taxes would be due on $40,000, or the gain realized on the investment.
There are two categories of capital gains taxation: 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 lower rate than short-term capital gains.
In the process of partitioning marital assets, equal isn’t always equitable when capital gains taxes are factored in. Consider these two examples.
Example 1: A pair of assets has a current value of $250,000 each. Let’s assume both are subject to a long-term capital gains tax rate of 15 percent at the time of sale.
|
|
ASSET 1 |
ASSET 2 |
|
Value |
$250,000 |
$250,000 |
|
Cost basis |
$100,000 |
$260,000 |
|
Gain/Loss |
$150,000 |
-$10,000 |
|
Taxes |
$22,500 |
$0 |
|
Net |
$227,500 |
$250,000 |
Example 2: A pair of assets each has the same current value and cost basis. The first was purchased in 2007; the second was purchased just 3 months ago. Let’s assume a 28 percent short-term capital gains tax rate.
|
|
LONG |
SHORT |
|
Value |
$250,000 |
$250,000 |
|
Cost basis |
$225,000 |
$225,000 |
|
Gain/Loss |
$25,000 |
$25,000 |
|
Taxes |
$3,750 |
$7,000 |
|
Net |
$246,250 |
$243,000 |
When negotiating a divorce settlement, be aware that the values listed on brokerage statements often do not correlate with an asset’s actual or potential financial benefit. Sometimes higher asset values camouflage huge future tax liabilities while smaller asset values can translate into higher gains. A neutral analyst, such as a Certified Divorce Financial Analyst, can help navigate these complexities for a settlement that benefits your long-term best interests.
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