In the turmoil of the end of your marriage, you may sign a divorce settlement agreement quickly, even with relief. That important – and possibly ill-considered – paper may start you on a new life. It might also ignite a tax nightmare for you in the future.
Here’s what to know about a few of the most relevant tax topics:
Capital gains. One path to a large and unexpected tax burden: sell investments, either a rental property or stocks or similar holdings that had a low original cost.
You incur tax for gains on your investment (possibly short- or long-term capital gains, taxed at different rates); the original cost of the asset, aka the cost basis, also resets to the investment’s fair market value, namely what it would fetch if sold now. On sale of rental property, you pay depreciation recapture, a sort of past-due for tax breaks you take for wear on the property over time.
If you sell your house (your primarily home), you and your spouse can each exclude the first $250,000 of gain from your taxable income. If you and your ex-spouse sell the house as you’re getting divorced, you can jointly exclude $500,000 of gain from tax if you lived there for two of the five years before the sale. The allocation of proceeds in the pending divorce is then up for negotiation.
You or your ex being in the military can extend that five-year period under some circumstances, and if you bought the house less than two years ago the exclusion may be reduced.
So if you bought your house many years ago, you may again want to put aside sufficient funds to pay taxes on the gain.
Alimony. Many divorcing people think that maintenance (aka alimony) is a nice way to get free income. Wrong, at least sometimes: If you receive alimony from your ex-spouse, you must include this amount in your income tax and your spouse can deduct it.
Plan to make quarterly estimated payments to the Internal Revenue Service to ensure that you don’t substantially underpay your income tax withholdings through the year.
Retirement accounts. If you or your soon-to-be ex-spouse has money in such plans, one of you will most likely share those assets as part of the agreement.
Let’s say your account gets split. If you transfer the money to an individual retirement account that’s in the name of your ex-spouse, you don’t pay income tax or a penalty for early withdrawal. Failure to do that often leads to a big tax hit, and you pay federal and often state income taxes at the ordinary income rate.
If you are younger than 59½, you pay a 10% penalty for early withdrawal from these accounts unless you take distributions in substantially equal annual payments for five years or until you turn 59½, whichever is later. The only exception: Take the funds from your ex-spouse’s 401(k) under a qualified domestic relations order.
Countless ways exist to unwittingly create a tax burden in a divorce. Before you sign that agreement, you may want to consult a financial expert, your financial advisor or a tax preparer to ensure you understand the potential ramifications.
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Wendy Spencer, CFP, CDFA, is president of Spencer Capital Strategies Inc., an independent Money Concepts contractor in Arvada, Colo. She is also a family law mediator; her divorce website is www.divorcemoneypro.com.
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