Make Divorce a Less Taxing Time

What you end up with depends in large part on your awareness of the tax benefits involved. They could save you, or your ex-spouse, a bundle

Suppose you and your spouse are calling it quits. You've got two jointly owned assets--a house and a retirement account--each worth $500,000. Would it make a difference which one you walked away with? You bet. Equal division of the assets does not mean equal tax bills. "If the tax implications of a divorce settlement are not taken into account, a spouse can unwittingly end up with less, sometimes substantially less, than he or she bargained for," says Cindy Wofford, a tax attorney in Washington.

The primary residence is one area a divorcing couple can get tripped up with costly mistakes. Those selling homes can qualify for generous tax breaks, but it takes some planning to make sure you can take advantage of them. A couple arranging a written separation agreement or divorce decree must include a "use of residence clause." That allows the spouse who moves out to continue to claim the home as a principal residence for tax purposes, says Ginita Wall, an accountant in San Diego who specializes in divorce settlements.

When a married couple files a joint tax return for the year they sell their house, they can exclude up to $500,000 of any profit ($250,000 per person) from capital-gains tax. That exclusion applies as long as one spouse has owned the house for two of the five years immediately prior to the sale and both spouses have lived in the home for the same time period.

As part of a divorce agreement, say the husband moves out of the house and the wife stays until the kids go off to college several years later, and then she sells it. For the husband to claim his $250,000 exclusion on the sale, the couple must include the use-of-residence clause in the divorce decree. Then, when the wife sells the home, the $500,000 exclusion remains intact, and the ex-spouses can split the gain on the home equally. If they didn't have a use-of-residence clause, the spouse who no longer lived in the house would lose the $250,000 exclusion on the sale and be subject to capital gains, state, and local taxes (table). Be aware that rental and vacation properties are treated differently than primary residences because they don't qualify for a $250,000 exclusion.

Divorcing couples also should pay attention to the tax implications of retirement benefits. If the transfer of assets from one spouse to another is not done properly, the monies withdrawn from the retirement account will be subject to taxes and early-withdrawal penalties.

To correctly divide retirement benefits, the couple needs to create a legal document called a qualified domestic relations order (QDRO). A QDRO helps a former spouse get his or her fair share of a retirement account accumulated during the marriage. With a QDRO, a husband or wife can transfer some of the assets from his or her retirement account into a separate IRA account for the ex-spouse without incurring taxes and penalties. Also, remember to account for the taxes that must be paid when the retirement account is drawn down. The best way, says Wall, is to use a 27% tax bracket to estimate the amount of taxes owed at retirement.

The easiest way to divide a diversified stock and bond portfolio with minimal tax consequences is to do the division prior to finalizing a divorce. That's because spouses can transfer assets to each other tax-free. So, if you have 500 shares of Microsoft, open an account for your soon-to-be ex-spouse and transfer 250 shares, tax-free. Once the divorce is final, splitting the assets is more difficult. The couple must figure out the cost basis for each stock, bond, and mutual fund, assess the appreciation or loss, account for the capital gains, and then try to split it evenly.

Equitably dividing assets in divorce is never easy, but you can make sure the financial nightmare doesn't continue long after the divorce is final.

By Toddi Gutner

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