The dissolution of a marriage is a very difficult and stressful experience and, without proper financial planning what appears to be equitable at the time of divorce can become very unequal over time.
Generally, no gain or loss is recognized on a transfer of property from one spouse to the other, or from a former spouse, if the transfer is incident to divorce. According to IRS Publication 504 Divorced or Separated Individuals, a property transfer is incident to divorce if the transfer occurs within one year after the date the marriage ends or is related to the ending of the marriage. Two conditions must occur for the property transfer to be considered related to the end of the marriage. The transfer is made under the original or modified divorce or separation instrument and the transfer occurs within 6 years after the date the marriage ends.
One area that frequently tends to be overlooked when dividing up the marital estate is determining the original cost basis of the property being received prior to accepting the distribution.
Consider the following scenario:
Sue and Bill have been married for 15 years. They have no children and are each currently in the 25% federal tax bracket. They are trying to decide how to equally divide their remaining three assets. Those remaining assets are as follows:
A beach house (investment property) worth $225,000
An IRA worth $50,000
A savings account worth $275,000
Bill has proposed that Sue take the investment property and the IRA while he retains the savings account. Sue thought this sounded fair since each would be getting half of the $550,000 remaining assets value. However, the question that she overlooked asking was "what is the basis of each asset?"
Had this question been asked it would have been revealed that Bill only paid $150,000 for the investment property when he purchased it years ago. Once the cost basis is subtracted from the current value, there is a long-term capital gain of $75,000. Taxes associated with this gain would cost Sue $11,250 (assuming a 15% federal long-term capital gain rate) plus $4,500 state tax due (6.0% Georgia state tax rate). In addition, Sue would also have to bear the expense of any real estate transactions costs associated with selling the property, which would only further diminish the remaining amount. In this example we did not factor the cost of any improvements that may have been made to the property. If, however, any allowable improvements had occurred they would be able to be classified as an adjustment to lower the capital gains tax on the sale.
In addition, the after-tax value of the IRA is approximately $37,500 (25% tax rate). Sue is under age 59 ½ so she would also incur a 10% early withdrawal penalty of $5,000.
The after-tax results show Sue ending up with only $241,750 while Bill keeps $275,000 tax-free and clear. If Sue had to sell either of these assets in the short-term this would have a negative tax effect and would hardly be considered an equal split. If the assets were being held for a number of years before sold, then the answer may be different. Issues such as any differences in tax bracket, the ability to defer gains (or losses) on the asset and other factors would need to be considered.
To avoid potentially nasty surprises, it is best to thoroughly investigate the basis in all assets prior to agreeing to accept transfer in order to have a clear picture of the financial outcome. Once the marital settlement agreement has been signed and the divorce is final there is little to no opportunity to renegotiate an unfavorable deal.