Tax Implications of Divorce: Working Toward an Equitable Split

Divorce results in the division of a household’s assets and income, but parties involved should consider that sometimes a split that appears equitable may not be.

• Some assets, whether securities or real estate, may have large unrealized capital gains or deferred income tax that could diminish their after-tax value. 
• A risk-averse spouse may end up with assets that have limited liquidity or a high-risk profile.
• Spousal support and child support may or may not keep up with the rising costs of living and may not be protected in the event that the higher-earning spouse no longer has the ability to generate income.

For these reasons and more, couples considering a separation need to review all of their assets and income needs in the context of their overall financial and tax picture. 

In this Insight, we review some of the most important considerations.

What are the implications of taxable versus tax-free assets?

At first glance, dividing assets in a divorce may seem straightforward, but the tax treatment of different assets can significantly affect their true value. An even “50-50” split on paper does not always mean an equitable outcome once taxes are factored in.

Consider the tax status of all assets divided between spouses:

• What are the unrealized capital gains for the taxable assets?
• What are the income-tax implications for each spouse, given his or her income level, of the tax-deferred or tax-free retirement assets, such as 401(k)s or IRAs?
• For a spouse who needs to draw on investments in the near term, will he or she be able to access the assets in a retirement account without early withdrawal penalties?
• Will the division of assets ensure that no one spouse is saddled with a disproportionate share of tax to pay?

For example, a traditional 401(k) or IRA is tax-deferred, meaning withdrawals will be subject to income tax, potentially reducing the after-tax value of the asset significantly. In contrast, a taxable investment account may contain unrealized capital gains, but withdrawals are not taxed as ordinary income and may offer more flexibility. Failing to account for these differences can lead to one spouse bearing a larger tax burden in the future. 

Ultimately, a fair division should not only consider the total value of assets but also their true after-tax impact and each spouse’s financial needs.

How are Social Security benefits affected by a divorce?

Divorced individuals may be eligible to claim Social Security benefits based on an ex-spouse’s earnings record, provided the marriage lasted at least 10 years, and they have not remarried, and both are at least 62 years old.

If both spouses are eligible for Social Security benefits based on their own working history, individuals may be able to replace theirs with their ex-spouse’s if the latter’s earnings and Social Security benefits are comparatively higher. Though divorced spouse Social Security benefits may replace individual ones, it does not create an opportunity for double payments.

What are the tax implications of retaining or parting with the household’s primary residence in a divorce?

When one spouse agrees to keep the primary residence as part of his or her distribution of marital assets, he or she may be unwittingly sacrificing financially for the comfort of remaining in a meaningful home:

1. A home is less liquid than marketable securities in an investment account; it’s difficult to predict how long it might take to sell real estate, and at what price.
2. A portfolio requires no repairs or maintenance, but a home needs upkeep, the cost of which could place a strain on the cash flow of the spouse who remains. In addition to routine maintenance and potential repairs, the spouse who keeps the home must cover insurance and property taxes, which can increase significantly over time. Property tax valuations may be reassessed post-divorce, particularly if the house is refinanced in one spouse’s name or if local tax laws change.
3. Like investment assets, a home could carry an unrealized gain that could create a significant tax bill upon its sale. A couple selling a home together may qualify for a $500,000 capital gain exclusion, provided they both meet the two-out-of-five-year residency rule. However, if only one former spouse retains the home and later sells it, the exclusion is reduced to $250,000, increasing the likelihood of a significant taxable gain.

If a couple originally purchased their home for $500,000 and it appreciates to $1.2 million by the time of sale, their combined capital gain would be $700,000. If sold while both spouses qualify, $500,000 of that gain would be tax-exempt, leaving only $200,000 subject to capital gains tax. However, if one spouse retains the home post-divorce and sells it years later (no longer meeting the joint residency requirement) only $250,000 of the gain is excluded, meaning $450,000 could be subject to taxation.

Given these potential tax consequences, it is essential to weigh whether keeping the home aligns with your long-term financial security. Consulting with a financial advisor can help determine whether retaining real estate is a sound decision compared to other divisible assets with greater flexibility and fewer long-term financial burdens.

Why Understanding Asset Risk Profile is Critical for an Equitable Divorce

Any household is likely to own investments that vary in risk, and naturally, there may be assets in the marital estate that do not reflect the preferences and goals of both spouses, especially in cases in which one spouse is uninvolved in the household’s investment decisions.

Assets should be reviewed in detail, in an effort to avoid a situation in which a spouse with a modest risk tolerance and limited investment knowledge ends up with, say, a portfolio of highly appreciated tech-company stocks, or an illiquid investment with high risk and little transparency.

Complexities for Valuing Complex Assets

When dividing assets in a divorce, determining the value of stocks, private business interests, professional practices, and deferred compensation plans can be far more complex than valuing straightforward assets like cash or real estate. These holdings often fluctuate in value, involve unique tax considerations, and/or lack immediate liquidity.

For business owners, valuation can be particularly intricate. Closely held businesses, private partnerships, and professional practices will typically require formal appraisals incorporating factors like future earnings potential, industry trends, and marketability restrictions.

State laws also play a significant role in valuation. In community property states, most assets acquired during the marriage (including business interests) are typically divided equally. In equitable distribution states, courts consider broader factors such as each spouse’s role in the business, specific contributions to its success, and overall financial circumstances as they determine a fair division.

Given these complexities, professional financial expertise can be crucial to ensure that both spouses receive an equitable share based on assets’ true value, risk, and tax implications. We take a deeper look at how to protect assets from divorce in this Insight.

How Do Alimony and Child Support Affect Taxes After a Divorce?

The details of alimony and child-support payments in divorce documents could create payments that will fall short of long-term needs, even if they cover current costs. An equitable agreement should include adjustments for inflation on support payments so that they keep pace with costs, particularly faster-growing costs in categories like medical and education.

Support payments based on a percentage of the higher-earning spouse’s income could be beneficial for the lower-earning spouse. When combined with a dollar-value minimum payment amount, this strategy could offer the lower-earning spouse both downside protection and a chance to capture the upside of the higher-earning spouse’s future income.

Also worth noting is that the Tax Cuts and Jobs Act of 2017 made a significant change to the taxation of alimony affecting divorces filed after 2018: alimony will no longer be taxable to the recipient, nor tax-deductible for the spouse making the payments.

Life and Long-Disability Insurance to Cover Future Child Support Payments

The higher-earning spouse might only be able to make alimony and child support payments if he or she has income. To help protect the lower-earning spouse and children, the divorce documents should include a requirement that the higher-earning spouse maintain life insurance and long-term disability insurance for the term of the support obligation. The benefit amounts should be calculated to meet the needs of the lower-earning spouse and children.

Potential Implications of Capital-Loss Tax Carryforwards

If a couple has a capital-loss carryforward amount on their joint tax return, this should be reviewed to determine how the amount will be allocated between spouses. A capital-loss carryforward can be used to offset capital gains that may be realized if a spouse wants to sell appreciated assets following the divorce, giving it special importance in a divorce.

Generally, the capital loss is divided according to which spouse’s assets incurred the loss. However, if the loss resulted from the disposition of jointly owned property, the carryforward amount is divided equally. In some states, the treatment of the carryforward amount is subject to negotiation in the division of assets, so there may be an opportunity to match the carryforward amount with assets with offsetting unrealized gains. You can learn more about the value of tax-loss harvesting strategies in our Insight here.

Expert Assistance Structuring a Fair Split

Due to all of the complexities outlined above, a detailed asset review is a critical foundation for understanding the context of each spouse’s total financial picture, and it’s recommended that you do so with your financial advisor.

With forethought and planning, a divorce agreement can be fair and favorable, allowing the separating spouses to begin the next chapters of their lives with the confidence that they have arrived at a positive resolution.

Could you benefit from working with a financial advisor while dividing your assets as part of your divorce agreement? Schedule a complimentary consultation with a member of our team today.