The Tax Implications of Divorce

William Donaldson, a certified financial planner and a certified divorce financial analyst, says in a divorce the failure to remember taxes leads to costly mistakes later.

Capital gains, income tax, and alimony are three taxes to remember in divorce negotiations.

Capital gains taxes need to be analyzed when property is being divided. Capital gains refer to the fair market value of an asset minus its cost. For example, if someone pays $5 for a share of stock that is is now worth $25, he has a capital gain of $20. This regime applies to other assets such as the family house, stocks and mutual funds.

Care must be taken that the property received in a settlement does not have large capital gains as compared with the spouse’s share of the pie.

For example, an investment account worth $150,000, with a cost basis of only $50,000 has a gain of $100,000 that the recipeient must pay at minimum long-term capital gains tax; moreoever, there may be short-term gains as well, which are taxed at their own marginal tax rate.

In the case of a marital home, the IRS eased the tax burden in 1997 by allowing a $250,000 capital gain exclusion per spouse if the couple lived there for at least 2 of the past 5 years. If the home is to be sold and there is a considerable gain in value (over $250,000), the spouses should consider selling before the divorce to take advantage of the full $500,000 exemption.

If the house was sold prior to 1997 and rolled over into a new house, and there was capital gain to the existing home, the old rules will apply to determine the cost basis of the current home. This increases the gain and possibly further the need to sell while still married.

Income taxes are effected primarily by alimony payments and filing status. Alimony received is taxable as ordinary income, so a $50,000 payment received is actually worth $35,000 after taxes, assuming a 30% marginal state and federal tax bracket. By the same token, the payer receives a tax deduction, so the same $50,000 payment actually costs the taxpayer $35,000 assuming the same tax bracket.

Filing status is an important decision after the divorce. A person still married on 12/31 of the tax year has the the option of filing a joint return. This can save considerable tax for both parties.

If a spouse divorced after 12/31 and he or she qualfies, filing as head of household versus single can also save considerable tax dollars.

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