Divorce: Understand the federal tax ramifications

In the event of a divorce, does it matter which marital assets are used for an equitable division?

When anticipating a divorce, it’s important to understand there are often major financial consequences and some important tax issues that need to be addressed.

The general rule is that the division of property, including cash, between divorcing spouses has no immediate federal income tax or federal gift tax consequences. Section 1041(a) of the Internal Revenue Code generally mandates tax-free treatment for transfers between spouses of real estate, personal property, investments held in taxable accounts, business ownership interests, and similar assets both before the divorce and at the time the divorce becomes final. Such transfers are considered gifts between spouses. As such, no federal income tax or federal gift tax is due.

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This same tax-free treatment also applies to post-divorce transfers between ex-spouses if they are made as an “incident to divorce.” Transfers incident to divorce mean those occurring within 1 year after the date the marriage is dissolved, or 6 years after that date, as long as the transfers are made pursuant to a divorce or separation agreement.

When a transfer falls under the tax-free transfer rule, the spouse (or ex-spouse) who receives the asset takes over the existing tax basis in the asset. The spouse who ends up owning appreciated assets (fair market value in excess of tax basis) must recognize taxable income or gain when those appreciated assets are sold (unless some exception applies, such as the exclusion for gain on sale of a principal residence). When one spouse ends up with 50% of the couple's assets in the form of cash while the other person ends up with 50% in the form of appreciated assets, a future tax liability will occur once sold. For this reason, divorce property settlements should be based on “net-of-tax values” defined as the fair market value of assets reduced by any built-in tax liabilities.  

NEXT: More on transfers "incident to divorce"

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Under the tax-free transfer rule, divorcing spouses can usually make tax-free transfers of investments held in taxable accounts while they are still married or when the divorce becomes final. The same is true for post-divorce transfers between the parties, provided they are made as an “incident to divorce.” Keep in mind that after a tax-free transfer is completed, the recipient spouse's tax basis in the investment is the same as before and so is the holding period.

The individual who winds up owning appreciated investment assets will ultimately owe the built-in tax liability that comes attached to those investments. So from a net-of-tax point of view, appreciated investments are worth less than an equal amount of cash or other assets that have not appreciated.

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Special care is required for any post-divorce transfers of appreciated assets to an ex-spouse. Such transfers are tax free only if they are considered incident to divorce. Within 1 year after the divorce, transfers automatically pass this test. For a later transfer to be considered as an “incident to divorce,” it must be shown that the transfer is related to the cessation of the marriage. This generally means the transfer must occur within 6 years of the divorce and be required under the divorce property settlement agreement (including any post-divorce amendments to the agreement).

If you plan to transfer appreciated assets to your ex-spouse more than 1 year after the divorce, the divorce papers should clearly identify such transactions as being part of the property settlement. Otherwise, you could be treated as making a taxable sale or a gift to your ex-spouse. This could result in a tax bill or it could reduce your $5.43 million federal gift tax exemption for 2015 (up from $5.34 million in 2014).

In addition to the overwhelming emotional impact, divorce is a major and often complicated financial transaction. As such, it has serious tax implications and potential tax pitfalls. Planning ahead is critical to getting good tax results, as is the importance of seeking competent legal and tax advice.

NEXT: Why is term life insurance so inexpensive compared to other policies?

Why is term life insurance so inexpensive compared to other polices?

Unlike permanent insurance, term insurance only pays a death benefit. That's one of the reasons term insurance tends to be less expensive than permanent insurance.

Many find term life insurance useful for covering specific financial responsibilities if they were to die unexpectedly. Term life insurance is often used to provide funds to cover:

• dependent care

• college education for dependents

• mortgages.

Several factors will affect the cost and availability of life insurance, including age, health, and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.

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