Death, Divorce, and Taxes
While the title of this article is quite cynical, it is prudent to note that the divorce rate in the United States is hovering around 50%, As such, it is important to understand the implications divorce will have on your taxes. A divorce is already an unpleasant affair, but that unpleasantness can be compounded when the IRS gets involved the fiscal year after your divorce is finalized. The purpose of this article is to provide you with practical information on divorce and taxes.
When transferring property (personal or real), it is essential that the transfer not produce gift tax liability or a taxable gain. Further, the person transferring the property will not be entitled to an estate tax marital deduction, so they do not want the transfer to be considered when calculating their taxable estate.
The transfer of property between spouses as a result of divorce will not be viewed as a loss or a gain. Further, “as a result of divorce” is defined as a transfer of property within one (1) year of the end of the marriage. The “end of the marriage” is occurs when the marriage ended as the result of a divorce/separation instrument.
The transfer of property rights pursuant to a “Property Settlement Agreement”, which in turn is included in a Court’s decree of divorce, will not be viewed as a gift and is therefore not an item that can be taxed as a gift.
If the “Property Settlement Agreement” is not included in the decree of divorce, there is another method of shielding the transferred property from the gift tax. If the transfer is the result of an agreement between spouses, and the agreement occurred between one (1) year before and within two (2) years after the divorce, the transfer will not be viewed as a gift. To the contrary, the transfer will be viewed as constituting full and adequate consideration (this simply means that the transfer was pursuant to a valid contract, and is therefore not a gift).
Harry (“H”) and Wendy (“W”) have been married for ten years. For one reason or another, H & W have a falling out, and seek a divorce. During the divorce, H & W come to an agreement about how the marital community should be divided (“marital community” is legal jargon for all the assets that are deemed community property). In the division, H decided he was ok with allowing W to take ownership of their $2.5M villa in the Hamptons, as well as their $300,000 Bentley. This agreement is then incorporated into the Court Order granting H & W a divorce. If this were not considered a transfer of property as the result of the end of marriage, gift tax would have been paid on a gift of $2.8M, this would be a significant amount of money! However, since the transfer is the result of an incorporated “Property Settlement Agreement”, the transfer is valid under general contract law, and is not viewed as a “gain” for W either.
Harry (“H”) and Wendy (“W”) have been married for ten years. H & W begin to have a falling out, and seek couple’s therapy. During therapy, they decide that if therapy doesn’t work, and they did eventually get divorced, W would receive the $2.5M villa in the Hamptons, as well as the $300,000 Bentley. Six (6) months later, the worst-case scenario occurs, and H & W get a divorce. Subsequently, H honors his agreement with W and transfers his property rights in the villa and the Bentley to W. When property is transferred without consideration, it is deemed a gift (“Consideration” is legal jargon for a “bargained for exchange”, which means that both people got something out of the agreement. Remember, a valid contract does not exist without an offer, an acceptance, and consideration). The United States taxes gifts over a specified amount (as of September 8, 2017, that number is $15,000). However, since H & W entered into the agreement within one (1) year prior to their divorce, the transfer is deemed to be as a result of the end of the marriage. As such, the transfer is deemed to be supported by consideration, and will not be subject to a gift tax.
In most divorces, one spouse makes more than the other spouse. Part of the Court’s job in a dissolution case is to create an equitable distribution of the community assets to place both people in a similar position to that which they were in during the marriage. This frequently includes payments from one spouse to the other, this is referred to as “alimony.” “Alimony” is specifically defined as the transfer of cash made under a divorce or separation instrument to a spouse or former spouse under the following conditions:
- The instrument defines the payment as alimony, and nothing else (e.g. child support);
- The payments do not extend beyond the life of the person paying the money;
- The instrument doesn’t prohibit the reduction of the amount paid as the result of external factors; and
- The parties do not live together when payments are made.
It should be noted that in some cases, payments to a third party are treated the same as a payment to the spouse (i.e. alimony). For example, if one spouse pays the other spouse’s mortgage, in lieu of cash, that payment is considered an alimony payment. The importance of determining whether something is “alimony” is that tax deductions may be made on the basis of alimony paid.
Further, alimony is not the same as child support payments, which are rarely deductible expenses for the individual making the payments and are no considered when determining the individual receiving the payment’s gross income for taxation purposes. There are many other types of payments, which do not count as alimony as well. Property settlements that are not made in cash are not “alimony” payments. Using the example of Harry and Wendy above, the transfer of the villa in the Hamptons and the Bentley are non-cash transfers and are therefore not “alimony.”
Once again, labeling something as “alimony” is no small matter. There are tax implications to transfers labeled as alimony. Namely, the person paying the alimony can deduct those payments from their taxes, and the person receiving the payments will have those payments included in the calculation of their gross income.
As a practical matter then, the spouse who will be obligated to pay alimony may prefer the non-cash property transfers to be at a minimum, while maximizing the amount of cash they must pay to the other party. This is because the payor will not be able to deduct the non-cash transfers when tax season comes, but he will be able to deduct his alimony payments.
In contrast, the person receiving the alimony payment will want a low alimony payment, and a high non-cash property so that her gross income is not distorted by the inclusion of alimony for taxation purposes. Further, since the non-cash transfers are not deemed gifts, the receiving spouse will enjoy the tax benefits of that as well.
Since labeling something as “alimony” can have a significant impact on a person’s taxes, many people have attempted to take advantage of the system. As a result, many laws have been enacted to prevent people from accomplishing that goal. For example, the law prohibits excessive “front-loading” of alimony payments. Excessive front-loading occurs when one spouse makes a massive alimony payment after divorce, and then pays a lesser amount the following months; this is an effort to alter their tax liabilities – it could even take the paying spouse to a lower tax bracket, giving them a net gain through alimony.
As you are likely aware after reading this article, careful planning is required when considering a property settlement in relation to divorce. With the assistance of competent lawyers and financial advisors, we can turn a financial loss into a final gain. If you and your spouse are contemplating a divorce, contact us today for a free consultation on your potential tax liabilities. After we have fully outline the financial implications of your divorce, we will work with you to generate an outcome that doesn’t result in financial woes the following tax season.