Financial Planning for July 2007

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Keep the IRS from Being the Only Winner in Your Divorce
According to most experts, living through a divorce is like living through the death of a loved one. It is no surprise, then, that many people pay an unnecessarily high tax price because of poor divorce planning – akin to paying higher estate taxes due to poor planning.

The timing of a divorce can be critical. If your divorce is close to year end, and you can choose whether the divorce is final before or after year end, take the time to calculate the tax effects of both options. If you divorce before year end, you will be considered single, but a divorce after year end keeps you married and able to file jointly for the year of divorce. The desire to reduce your tax burden, though, should also be evaluated in light of your level of trust in your spouse relative to financial matters. Never put yourself at greater risk only to reduce your tax burden.

Property settlement issues can be particularly difficult, especially if you have highly appreciated assets. Unless you or your spouse is a resident alien, transfers of assets incidental to a divorce are tax free. However, you can be a loser if your spouse gets property that is worth the same as your basis while you get highly appreciated property. A quick example: assume you have two assets worth $10 million and that one has a tax basis of $10 million while the other has a tax basis of $1 million. The spouse who receives the property that has a basis of $1 million will eventually pay taxes on the $9 million gain at a minimum of 15% when the property is sold. The spouse receiving the property with a $10 million basis will pay no taxes if it is sold for $10 million. The net result is that the spouse receiving the gain property gets $8,650,000 in value, while the other spouse receives $10,000,000 in value.

If you, your spouse, or both of you have a qualified retirement plan to be split, make sure the court issues a Qualified Domestic Relations Order (QDRO). By doing so, the spouse receiving the distribution will be able to avoid the 10% penalty for early withdrawal (should he or she choose to spend the money). One thing you should never do is take a distribution from your qualified plan and then give the money to your spouse. This will subject you to all the taxes and penalties on early distributions, assuming you are under age 59 ½.

Child support is not deductible to the party who pays it, or includible in income for the payee, since it is basically an obligation a parent has to a child. You should therefore try to minimize the portion of a settlement allocated as child support, unless you will be paying the child support for a short period of time because of your child’s age. Maximizing child support that will be paid only one or two years, in exchange for reduced alimony payments that could last forever, could save a great deal of money.

Don’t forget to negotiate who gets the exemptions for the kids. Even though a child may live with one parent, the divorce settlement will dictate who takes the child as a deduction on their tax return. There are numerous arrangements that can be made to allow both spouses to take the dependency exemption. For example, you may wish to take the exemption in alternate years. Use Form 8332 to make the assignment of exemption(s). Remember: whoever gets the dependency exemption also has the right to take educational deductions or credits. The availability of the dependency exemption does not affect who gets the child care credit - this will always be available only to the custodial parent.

The family home can be another source of contention, especially if it is highly appreciated. Assume you purchased your home for $250,000, but it will sell for a net of $750,000. If you divorce, then sell the house more than three years after the divorce, only the spouse living in the home will receive an exemption of $250,000. That means tax will be paid on half the gain. If the property is sold within three years of the date your divorce is finalized, you and your spouse will be able to take the $250,000 exemption, thus eliminating the tax.

Alimony paid pursuant to a court order is deductible by the payer and includible in income by the recipient. For this reason, the spouse paying alimony generally seeks to maximize the alimony payment and minimize the child support payment. As previously discussed, you should take into account the length of time you will be paying both of these items before making a final settlement.

These are just a few of the tax considerations in a divorce. It’s bad enough to live through the process, so don’t compound the pain by structuring your financial settlement to overpay taxes. As with most things related to tax issues, it’s wise to consult a professional before signing a final deal, so seek out your CPA’s advice. If you don’t have a CPA, give us a call. We will be glad to assist you in any way we can.

Happy Fourth of July!


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