The tax issues that can arise when you and your spouse split marital property can be extremely complex. It is important that you ask your attorney about these tax consequences and address them early on in the process. Your attorney may advise you to consult a Certified Public Accountant to address your more complex investments. Below, we will address various types of property transfers to consider:
Tax laws allow spouses to transfer property to each other without recognizing a gain or loss if that transfer is the result of divorce. In fact, to qualify, the parties need not be actually divorced, rather the transfer must have been made with the intent to separate or divorce. These transfers typically have documentation that specify that the transfer is being made tax-free, but formal documentation is not required. Transfers made related to the end of the marriage or within one year of the end of the marriage are presumed to be divorce-related, and therefore tax-free. However, even with documentation, any tax-free transfers must occur within six years of the end of the marriage or it will no longer receive tax-free consideration.
When the property is transferred to someone else, a third party, the spouse receiving the benefit of the transfer will have to report the capital gain as income when filing his or her taxes. Federal and state income tax will apply to the gain. How much tax is owed will depend on the amount of the gain, the spouse’s tax bracket, and how long the asset was held before the sale. Even if the transfer to a third party was mandated by a separation agreement, capital gain tax will still apply. The only exception to this rule is if one spouse transfers property to a third party for the benefit of the other spouse; then the transfer would be tax-free.
There are a number of types of retirement accounts and each one has distinct tax benefits and consequence. You may have a 401(k), mutual funds, pension plan, IRA, or some other type of savings. Your retirement account is probably in just your name; however, the money earned or added to it during your marriage is considered marital property that must be split with your spouse.
Many of these accounts trigger their own tax consequences, even when the owner is trying to make a tax-free transfer. For instance, even if you cash in your 401(k) early with the intent of splitting it with your spouse, you will trigger taxes to owe. This could result in a tremendous tax burden for you, and could potentially push you into the next tax bracket.
For certain qualified employer plans, like a 401(k) and pension plan, you will need to obtain a Qualified Domestic Relations Order (QDRO). A QDRO is a legal tool, signed by a judge, which allows you to assign a right to claim money from a retirement account to another person. It will order the administrator take money from the retirement account to split the funds and send money to your spouse. It is important to note: a separation agreement alone will not work the same way. You must have a QDRO for the administrator to disperse the money this way.
For an IRA, there is no need for a QDRO if you have a court-approved divorce decree or separation agreement. It will be classified as a rollover or transfer and is non-taxable if the funds are deposited into another retirement account. The agreement or decree that orders the rollover or transfer must be very specific to include who owns the account, what amount is to be transferred, and the relevant account numbers.
Splitting stock options between spouses can get very complicated. Stock options are difficult to value when they haven’t been utilized. It is also difficult to determine whether stock options should be classified as marital property jointly shared or separate property. Once a stock option is classified and valued, it can still trigger complex tax consequences. Stock options must also be further classified as “statutory stock options” and “non-statutory stock options,” each with a different tax burden.
Non-statutory stock options are taxed at the usual rate upon being exercised. They can be transferred tax-free incident to divorce, and taxes will not be assessed until the option is exercised. Once exercised, they are subject to withholding at the supplemental withholding rate and FICA taxes will be deducted.
Statutory stock options are taxed based upon the capital gains, or profits, made when they are sold. However, when they are transferred, they become non-statutory stock options. Statutory stock options have more tax benefits, so they should be split with the spouse without truly transferring them. One option to achieve this is to agree to a set value that the option will be worth when exercised, and receive that amount as a lump sum from the other spouse. Another way is to get a court order or include a provision in the separation agreement stating that the spouse owning the option will hold them on behalf of the other spouse. The other spouse can direct the owning spouse to exercise at any time he or she wishes. Since this will trigger a tax burden, the agreement should state that the receiving spouse will receive the post-tax amount.
Your home is probably the largest asset that will be subject to division in the divorce. While there are several ways to split the home, some trigger tax consequences and others are tax-free.
If one of the spouses plans to remain living in the home, they can agree for the remaining spouse to “buy out” the other spouse’s half of the home or the other spouse can take his or her share of the home’s value in other property. This will not trigger any taxes. If both spouses agree to sell the home and split the profits, this will generate a capital gain for each spouse. Under current tax law, however, the spouses may exclude up to $250,000 in gain based upon sale or transfer of ownership of their primary residence. Finally, if the spouses choose not to sell the home, there is no tax consequence generated.
Spouses are not required to maintain a life insurance policy with the former spouse as a beneficiary. However, a spouse may choose to do so or be required to do so in the separation agreement. This often occurs as a form of insurance for future alimony payments in case the supporting spouse dies. Life insurance policies are tax-free when transferred incident to divorce, and therefore not taxable.