5 tax implications to consider during a divorce
In many divorces, particularly those involving high-value assets, lack of proper focus on property division may lead to costly tax errors. It is vital for spouses to fully understand tax implications during a divorce, as seemingly minor decisions can lead to future complications.
Below are five issues to consider related to taxes and divorce.
- Property settlements are not taxable…usually – Section 1040 of the IRS tax code states that there is no tax in a property settlement to either party. However, this is only the case if you meet specific requirements in Section 1041 or 2516. For many wealthy couples, property transfers in a divorce decree may be subject to either income tax or gift tax. Additionally, even if your property settlement is tax free, you still need to consider future taxes on the property.
- Transfers are tax-free within one year after a marriage ends – According to Section 1041 of the tax code, property transfers that occur within one year after the end of the marriage are considered “incident to divorce,” and therefore tax-free. Transfers after one year are not necessarily taxed, but will be subject to evaluation by the IRS.
- Retirement accounts can cause tax issues – Although they may be tax-free now, IRAs and other retirement accounts will be taxed when they start paying out. Additionally, dividing workplace 401(k)s can be complex, and may require a Qualified Domestic Relations Order (QDRO) to avoid immediate taxation.
- Division of businesses may or may not trigger taxes – There are many ways to divide a business during the divorce process. If one spouse buys out the other, this can potentially be considered a taxable sale, depending on the circumstances.
- Alimony has tax implications, child support does not – Divorcing spouses may incorrectly assume that, like child support, alimony has no impact on taxes. In reality, alimony payments are tax-deductible for the payer and considered taxable income for the payee.