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Divorce: Making Sense of the Confusion

June 3, 2014
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by J. Kevin Stophel

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Recently, we had noticed that a client-couple had not been showing up together for our review meetings. The husband would show up to a meeting by himself and then for the next the wife would show up by herself. These were long-time clients and we had never experienced this with them before and we were wondering what was going on behind the smiles. After about a year, the fake smiles stopped and the wife told us they had separated preparatory to a divorce. After almost 40 years of marriage, they had decided to amicably part ways. As the wife told us this, she expressed confusion over what the process would be like and what the future would hold and asked us to explain some basic issues to her, which we did.

Dividing the property

The first issue we addressed was property division. We explained that most states allow a spouse to exclude inherited property, gifts and pre-marriage property from division. It is most common for states to require equal division of marital property, that property which isn’t excluded by being in one of the categories noted above. In regard to this property, from a division perspective, it is a good practice to consider the after-tax value of each particular piece of marital property, as it tends to be better to keep property with little capital gains tax exposure while transferring properties that have more substantial capital gains tax exposure. In some instances, like in the amicable divorce she described, it can even make sense to consider future taxation related to transferred assets and shift low basis assets to the low income spouse to achieve after-tax settlement balancing.

Dealing with retirement accounts

Retirement account balances were discussed next. Although she thought both spouses’ corporate retirement account balances were not part of the marital property subject to division, we explained to her that such wasn’t the case. We told her to expect a qualified domestic relations order (QDRO) to be issued by the court to indicate the specifics related to the division of these assets. Qualified retirement plan benefits can be split pursuant to a QDRO to meet property division, alimony or child support requirements. If one spouse becomes the recipient of the other spouse’s benefit, then they will normally be able to treat the benefit in the same manner as the other spouse but will not incur a 10% early withdrawal penalty. QDROs can’t be used to divide IRAs and these normally come under state property division regulations that also commonly allow for a carryover basis without taxation on transferred assets.

Talking about taxes

We then talked through the fact that the written separation agreement she had was not an official notice of divorce and that for tax filing they could still file as Married Filing Jointly (MFJ), if they desired. Tax filing status affects tax rates, filling requirements, deductions, credits, and income calculations, so agreeing on how best to file could save money. Although taxes would probably be lower if they filed MFJ, there could be some risk if the other spouse doesn’t pay their share as joint returns do expose each joint filer to the full tax, interest and penalties of the filed return. Filing separately (MFS) can reduce this risk, but will often lead to a higher overall tax being paid. Once divorced, we told her she would have to start filing as Single, but that such would probably lead to lower taxation than MFS.

Splitting the home

At this point, she asked us about their home and how they could split it. We knew she loved the home and would want to keep it, so we explained some options to her. We told her that It is common for one spouse to keep the home and the other to move out of the home. Although people often refer to this as one spouse ‘buying’ the home from the other, this is really just a non-taxable transfer of assets under a states’ property division rules. Generally, if the property transfer is completed within one year of the finalization of the divorce, the transfer is treated as property obtained by gift and the basis for the receiving spouse is the adjusted basis of the transferring spouse. If a divorcing couple sells a home, they may qualify for the capital gain exclusion on a primary residence ($250,000 individually or $500,000 jointly) if occupancy requirements are met. If they decide to continue to own the home jointly but only one spouse lives in the home, a portion of the mortgage payment could be deemed alimony being paid by the non-resident spouse. But, as long as one of the ex-spouses continues to live in the home, the capital gains tax exclusion remains in force.

Negotiating fees

Lastly, she told us that a friend who had gone through a divorce had told her that she could deduct the fees she would pay for the divorce and asked us if this was true. We told her that fees related to tax advice or income production could be deductible under an exception, but that documentation would be required to substantiate that the fees were directly related to such issues. Some tax-related issues encountered during the divorce process can include alimony taxation, child support taxation, qualified account distribution taxation and capital gains taxation related to the property division. Fees related to obtaining distributions from qualified plans or attempts to obtain alimony are a couple of examples of those related to production of income. These types of fees could qualify for deductibility. We also told her that at times, one spouse will pay the other spouse’s legal fees but that such payments weren’t deductible unless classified as alimony.

In this case, there were no children involved so we did not have to discuss issues related to child custody or support and alimony may not be part of the settlement as both spouses work and make good money, so we did not address this either. Although it is unfortunate that the couple feels the need to divorce, we believe we took some of the anxiety out of the process by providing some education on issues related to the proceedings and helped our client perceive a financially stable future.