Tax-Free Transfers
The tax implications of dividing marital property can create a bit of a headache. Most couples have multiple types of property; personal property, real property, investment and retirement accounts, and even business interests. It is crucial for both spouses to identify and consider relevant tax consequences that can occur when dividing assets and liabilities.
It is important to note that prior to 1984, when spouses transferred property incident to separation, the result was that the transfer was treated as a loss or a gain and was reflected as such by the IRS. Fortunately, the Tax Reform Act changed the law, allowing spouses to transfer property, incident to divorce, without recognizing and reporting a loss or gain.
Regardless of what this transfer is called (gift, sale, exchange, etc.) the same rule applies. The rule also applies even if the parties never obtain a divorce decree; the term “incident to divorce” doesn’t actually require that the parties divorce.
Generally a provision will be included in the legal document discussing the transfer, stating that any transfer will be tax-free. However, even if transfers occur with no legal document in place, there is often a presumption that the transfer was “incident to divorce” and therefore is free of tax consequences. In order for this presumption to take effect, the exchange of property must be related to the end of the marriage, or take place within one calendar year of the end of the marriage. Bear in mind that even if the transfer is prescribed by a legal document, it must occur within 6 years of the end of the marriage or the transfer will no longer be considered tax-free.
If property is transferred to a third party incident to divorce, however, the spouse who receives a benefit from the transfer will include the capital gain amount as income in filing his or her taxes. Both Federal and State capital income gain tax will apply. The amount of tax a spouse will have to pay on such a gain will depend on the applicable tax bracket and how long the asset was held before the sale. So, even though a sale of the marital residence to a third party may be incident to divorce, and mandated by the separation agreement, capital gain tax will still apply.
There is an exception to the third party rule stated above. Such a transfer can still be treated as tax-free in the event that the transfer to the third party is for the benefit of the spouse. For instance, if one spouse transfers funds directly to a bank to satisfy a debt owed by the other spouse, such a transfer can be considered tax-free. To be safe, the separation agreement or other legal instrument that discusses the transfer should state clearly that it is for the benefit of the spouse and is intended to be a tax-free transfer.
Despite this tax-free transfer rule, certain transfers inherently create taxable events that both spouses should be aware of.
Retirement Accounts
There are numerous retirement accounts available today; 401ks, mutual funds, pensions, IRAs, mutual funds, and the list goes on. Each of these accounts has favorable tax qualities to incentivize people to save for retirement. Although any given retirement account may only belong to one spouse, money earned or contributed to a retirement account during the course of a marriage is considered martial property and must be split in some fashion upon the dissolution of a marriage.
Regardless of the IRS rule allowing for tax-free transfers between spouses, there are certain tax implications that will get automatically triggered when retirement accounts are transferred. If you simply close an IRA or cash in a 401K early in order to split the funds with your former spouse, it will nonetheless create a taxable event and there could be serious financial consequences.
For qualified employer plans such as 401Ks and pensions, the best way to ensure that transferring all or a portion of the funds to a former spouse doesn’t result in tax penalties is to obtain a Qualified Domestic Relations Order (QDRO).
A QDRO, simply put. is a legal instrument that allows for a person to assign rights in a retirement account to another person. This order will allow the account to be separated and withdrawn with no tax penalty, so long as the funds are deposited in another retirement account. The order will itself will be sent to the plan administrator after it is signed by a judge, and it will instruct the administrator as to how the funds are to be dispersed.
Keep in mind that simply addressing how the account should be split in your separation agreement will not give you the same result – the plan administrator will not disperse a share of the plan without a valid QDRO. Similarly, if the owner of the qualified plan simply withdraws the funds directly from the plan to disperse them it will trigger a taxable event. Not only will taxes be owed because of early withdrawal, but the withdrawal could even propel that spouse into a higher tax bracket, cause your other investments to be hit with surtaxes, and even cause some of exemptions you would be otherwise eligible to hit the phase-out threshold. This domino effect can easily be avoided by executing valid QDRO.
If the retirement account in question is an IRA, rather than a qualified plan, there is no need to obtain a QDRO. The balance of an IRA can be divided, tax-free, if appropriately included in a court-approved divorce decree or separation agreement. This transaction will either be characterized as a transfer or a rollover, and is a non-taxable transaction so long as the funds are deposited in another retirement account. The legal instrument that prescribes the rollover or transfer will need to be detailed and include information as to who owns the account, what percentage is to be transferred, and even include the relevant account numbers.
Stock Options
If spouses are splitting stock options, this can create a quite a headache. First, it is often difficult to place a value on options not yet exercised. Unlike a vehicle or home, the fair market value of unexercised stock options is truly hard to attach a dollar amount to. Additionally, it can be hard to determine if the options are in fact marital property, or should be considered separate – this question is hard to answer unless it is clear that the options were granted as a reward for work done during the marriage.
After it is determined that the options are marital, and a value has been attached to the options, the tax consequences will need to be addressed. The tax penalty that will occur when transferring stock options is a function of whether the options are “statutory stock options” or “non-statutory stock options.”
The transfer of the latter type of option will result in the income being taxed at the usual rate upon the option being exercised. These options can be transferred tax-free incident to divorce, and taxes will not be assessed until the option is exercised. Once these options are exercised they will be subject to withholding at the supplemental withholding rate and FICA taxes will be deducted.
Statutory stock options are treated differently, however. When statutory stock options are sold, the resulting consequence is capital gain treatment from the profits acquired when sold. When statutory stock options are transferred, however, they lose their status as statutory stock options and become non-statutory options. Statutory stock options have more favorable tax treatment, so it is advised that the receiving spouse consider ways to obtain the options without executing a true transfer.
One option is to agree to a monetary value that the options will be worth once exercisable, and simply receive that amount as a lump sum from the other spouse. Another option is to include a provision in the separation agreement or court order expressing that the employee-spouse who owns the options will hold them on behalf of the other spouse. The spouse who is owed the options will have the authority to ask the other spouse to exercise the option at any time per his or her wishes. Because there will be a tax consequence when the options are exercised, the spouses should agree that the receiving spouse only takes the amount left after the tax penalty has been assessed.
Obviously, transferring stock options can create quite a headache from a tax standpoint. It is advisable to consult with an attorney or CPA before transferring any stock options so both spouses are fully aware of any tax consequences in advance.
Marital Residence
Let’s take a moment to discuss tax implications regarding the division of the marital home, as this is typically the largest asset subject to division and the marital residence will undoubtedly be divided in one way or another upon the cessation of the marriage. There are several ways to divide the property, some will trigger a tax event and others will qualify as a tax-free transfer incident to divorce.
If one spouse remains in the marital residence, and the other spouse takes his or her “share” of the home by taking other property, there will be no tax issue. Similarly, If one spouse takes possession of the home by buying the other spouse out, this transfer will be tax-free.
On the other hand, if the spouses decide to sell the home and divide the proceeds, both spouses will owe capital gain taxes to the extent there was a gain by each party. But if the spouses chose this option, they will be entitled to an exclusion of up to $250,000 in gain based on the sale or transfer of ownership in the principal residence. This exclusion applies so long as this was the principal residence of the parties and the ownership and use test mandated by the IRS is met.
And if both spouses continue to own the residence, no immediate tax event is triggered. Sometimes this is the preferable where one parent stays in the home with the children, and the intent is not to sell the home until years later. In that case, the spouse that stayed in the home will recognize any gain from the sale, and the same $250,000 exclusion will apply.
Life Insurance
There is no requirement that either spouse maintain a life insurance policy naming the former spouse as a beneficiary. However, some spouses may agree to do so anyway, and memorialize such in a separation agreement. For instance, perhaps a dependent spouse may require the supporting spouse to maintain a life insurance policy to secure future alimony payments so that in the event of the supporting spouse’s death, the dependent spouse would still have support in the form of the life insurance policy. Life insurance policies fall under the tax-free when incident to divorce category, thus any transfer of a policy will not be taxable.
Address Tax Issues Early
Tax issues that arise upon splitting marital property can be complex, so it is best to address these concerns early in your divorce proceedings. Speak openly to your attorney about any tax concerns, and consider consulting with a CPA if the investments at play in your situation are particularly complex. Not taking the tax consequences of splitting assets seriously could result in major financial loss, so it is best to give yourself plenty of time to address the tax implications of splitting marital assets.
