It is critical to consider taxes when evaluating the terms property division terms of any divorce decree. This article discusses 4 common tax issues that arise in a divorce case.
Built In Taxable Gains
Let’s begin with a common tax issue affecting property division in a divorce.
Some assets have a built in taxable gain. Some assets do not. Let’s demonstrate this issue by considering two assets commonly found in a divorce case.
The first asset is the marital homestead. Let’s say it is worth $200,000. The second asset is a non-qualified brokerage account with stock valued at $200,000. In this case, the couple only paid $100,000 for that stock. The rest of the value comes from growth.
If one spouse is awarded the house and the other spouse is awarded the brokerage account, then that initially seems to be an equal division. However, if the spouse that receives the house then sells the house, that spouse will receive the full $200,000 value and pay no taxes on the sale. This is true even if the house grew in value.
But if the other spouse sold the stock in the brokerage account, then that spouse would pay taxes on the taxable gain from the sale of the stock. That taxable gain is $100,000.
So the net result is that this property division is not equitable because you must account for those taxable gains.
Taxes and Retirement Accounts In Divorce
Retirement accounts are often qualified accounts – which means that they are pre-tax accounts. So no taxes were paid on the funds that the spouses deposited into the accounts. Exceptions to this rule include Roth IRA’s and Roth 401k’s which are post-tax accounts.
This means that you must pay taxes on withdrawals from qualified retirement accounts. So you must account for those taxes when evaluating how assets are divided in the divorce.
While dividing retirement accounts in a divorce should be a non-taxable event, it is important to make sure to divide retirement accounts properly in your divorce to avoid penalties and taxes.
Taxability of Child Support and Spousal Maintenance
It is important to consider who pays taxes on child support payments and spousal maintenance payments as well. The law recently changed on this so the answer will depend on the date of the divorce decree.
For divorce decrees entered on or before December 31, 2018, the child support and spousal maintenance payments are deductible by the payor and taxable to the recipient
For divorce decrees entered on or after January 1, 2019, the child support and spousal maintenance payments are no longer deductible by the payor and no longer taxable for the recipient.
This results in a significant tax benefit to the recipient of child support and spousal maintenance payments going forward.
Child Dependency Exemption and Child Tax Credit
The child dependency exemption and the child tax credit are two important tax benefits that you should consider in any divorce involving children.
The IRS rules state that the primary parent is entitled to claim the child as a dependent and claim the child tax credit. The primary parent is the parent with the right to designate the primary residence in Texas as that parent has possession of the child for the greatest period of time during the year.
However, this is a property right that may be allocated between the parents as part of the divorce. This means that the parties can allocate the right to claim the child or children however they wish and the IRS will respect that allocation.
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