Tip #15 -- Flying Solo Divorce Tax Pitfalls and Tips

Taxation and divorce don't mix -- unless your lawyer has down his or her homework. Here are some common mistakes that you can help avoid:

BEFORE DIVIDING UP THE PIE, DON'T FORGET TO CONSIDER BOTH THE COST AND VALUE OF ASSETS

Section 1041 of the Internal Revenue Code provides that transfers of property which are part of the divorce process are not taxable events. This means that a spouse who transfers property to the other spouse doesn't have to recognize any gain or loss, and the basis of the property doesn't change -- regardless of whether the property was owned separately or jointly.

If, for example, Joe and Jane bought a home for $50,000, owned it jointly, and it is worth $100,000 at the time of divorce. Because Jane wants to live there, she pays Joe $50,000 for his half interest. Joe will get the $50,000 free of income tax, but if Jane goes to sell the house later, she will pay taxes on the total $50,000 gain. There are a number of exceptions, such as transfers to trusts and Unites States Savings Bonds that should be considered.

That's why before a division is made, there should be a schedule of assets which include cost, value, and after tax value. After-tax value generally should be calculated based on the assumption that the asset will be sold immediately. However, if that assumption works against the holder of the asset, you might want to argue that the asset probably won't be sold soon and the after-tax value should be adjusted accordingly.

DON'T ASSUME THAT THE CAPITAL GAINS TAX YOU MAY PAY WILL BE BASED ON YOUR SHARE OF THE PROCEEDS

What if a divorcing husband and wife sell their jointly owned home with wife getting 80% of the proceeds and husband 20%? Although many assume husband will be liable for only 20% of the tax, they are wrong because the way in which proceeds from the sale of jointly-owned property is divided has nothing to do with the tax consequences. In this example, husband will be liable for one-half of the tax, regardless of the size of his share.

But there are some ways to avoid this problem:

1. Divide the ownership of the property before the sale. In this example, wife would be deeded 80% of the title before the sale so her property interest will be equal to her share of the proceeds.

2. Divide the proceeds so that the husband will receive additional money with which to pay the extra tax burden.

3. If each spouse agrees to report their gain according to the division of the proceeds, this will work if both do what they say. But it is risky because one spouse may not cooperate. That's why there needs to be indemnification if this option is used.

DON'T LOSE THE BENEFIT OF BUYING ANOTHER HOUSE IN TWO YEARS

If you sell your principal residence and buys a new one within two years, the capital gain can be deferred or "rolled over" into the new home according to Section 1034 of the Internal Revenue Code.

But there's a major pitfall in divorces when one of the spouses moves out of the marital home before it is sold and loses the benefit of the rollover because the home will no longer be considered to be that spouse's "principal residence" at the time of the sale. A home is classified as a "principal residence" under Internal Revenue Code Section 121 if the spouse lived there for three of the past five years.

How can this problem be avoided:

1. KEEP TIES TO THE HOME TO SHOW AN INTENT TO RETURN: If the house is to be sold soon after one spouses moves out, by keeping ties with the home, the moving spouse can demonstrate an "intent to return" through the date of the sale - which has led some courts to allow moving spouses to use the rollover. Examples of acts that may lead to this conclusion are: Rent an apartment or house, and don't buy after moving out. Document in writing that the reason for you leaving was solely to reduce emotional distress. Continue to receive your mail at the home. Leave some of your belongings there; and Do routine maintenance and yardwork around the house.

2. LIST THE HOME FOR SALE BEFORE THE SPOUSE MOVES OUT: Some courts have allowed the moving spouse to use the rollover so long as the house was listed for sale before he or she moved out

3. CONTINUE TO SHARE THE HOME: If there is no chance of physical harm and if there are not problems in your state courts, both spouses can stay in the home in separate bedrooms until the sale.

4. COMPENSATE THE MOVING SPOUSE FOR THE LOSS OF THE ROLLOVER: If it does not appear that the home will be sold in a short period of time, the moving spouse should negotiate for extra money in the settlement to compensate him or her for the loss of the rollover benefit.

5. CASH OUT OF THE HOME OR GET OTHER PROPERTY INSTEAD OF THE HOME: If financing can be arranged, the remaining spouse could take full ownership of the home and the moving spouse could either get his/her equity or additional assets tax free.

DON'T LOSE THE "'55 or Over" EXCLUSION

According to Section 121 of the Internal Revenue Code, people who are age 55 or over can exclude up to $125,000 of gain from the sale of a principal residence - regardless of whether or not another residence is sole. If you are eligible for this exclusion, you may wish to consider selling the home after the divorce because if the sale occurs before the divorce, the couple can exclude a total of only $125,000 (or $62,500 each if filing separately) while, if the sale takes place post divorce, each spouse can take advantage of the full $125,000 exclusion - even if only one of the spouses owns the house separately.

But if one spouse owns the house separately and sells it pre-divorce and takes the exclusion, the other spouse will be forever barred from using it. This won't occur so long as the sale takes place post-divorce. You should also consider consideration that if the house is sold before divorce, both spouses must consent to the use of the exclusion -- even if only one spouse uses it. This means that one spouse could block the other's tax planning.

If, however, one of the spouses is 55 or over and the other is not, if the house is sold before divorce, then, so long as a joint tax return is filed, the couple can use the exclusion together.

The "principal residence" problems where a spouse must live in the residence for three of the past five years is generally inapplicable here - meaning that you won't have the problem of a spouse moving out like you do when you have the rollover issue under Section 1034.

DON'T TRY TO DISGUISE CHILD SUPPORT AS ALIMONY

Sometimes, divorcing couples get the bright idea that if they call child support "alimony," the payor in the higher tax bracket will be able to deduct otherwise non-deductible payments. The problem: If the payments are reduced or end at or near a "child-related event" -- such as a child's attaining a specific age or income level, dying, marrying, leaving school, leaving the spouse's household or gaining employment -- the IRS won't be fooled and will treat the payments as child support, regardless of what the parents call them in their agreement. As a general rule, if alimony payments reduce or terminate within six months of a "child-related event," it will be presumed that the payments are child support.

If the payments are intended as alimony, the agreement should provide that the payor will deduct them and the payee will include them in income and that each will indemnify the other for any financial discrepancies should the payments be treated otherwise by the taxing authority.

MAKE SURE ALIMONY IS SPECIFIED TO END AT THE PAYEE'S DEATH

The rule is simple, but often overlooked: a series of alimony payments will be treated as a property settlement if there is the chance they could continue past the recipient's death according to Section 71(b) of the Internal Revenue Code.

For example, if instead of paying a lump sum or $12,000 to his wife, the husband

agrees to pay his wife $1,000 per month as taxable alimony for 12 months. If the agreement doesn't say that the payments will end on Wife's death, if Wife dies after six months, the IRS could treat the payments as property settlement which is not taxable to wife and not deductible to Husband.

If state law provides that payments of spousal support automatically terminate on the death of the payee, you might not have to specifically make the statement; however, there is no harm in the agreement providing that the payments will stop upon the death of the payee. In this way, you make sure that the payments are taxable/deductible alimony.

DON'T STOP ALIMONY PAYMENTS TOO QUICKLY

If alimony payments stop too quickly during the first three calendar years of payments, the IRS will take the position that some of the payments are actually part of a property settlement -- and therefore not deductible to payor and not taxable to payee. This will result in a "recapture" of some of the payments -- meaning that the payor will pay taxes previously deducted in the third year and the payee will get a corresponding deduction.

Quite a few lawyers mistakenly think there will be no recapture if the payments are reduced by $15,000 each year. Here's how the calculation works:

1. If the total payments paid in Year 2 are more than $15,000 larger than the total payments paid in Year 3, the excess is "recaptured."

2. The total payments paid in Year 2 (less any recapture) and the total payments paid in Year 3 are averaged and if the total payments paid in Year 1 is more

than $15,000 larger than this average, the excess is "recaptured."

The sums recaptured are treated as income to the payor in Year 3, and are deductible to the payee in that same year.

Let's assume that a husband pays $50,000 in Year 1, $10,000 in Year 2, and nothing in Year 3. Since the amount paid in Year 2 ($10,000) isn't $15,000 more than the amount paid in Year 3 ($0), there is no recapture in step one. In step two, the Year 2 and Year 3 amounts ($10,000 and $0) are averaged, which is $5,000. Since the amount paid in Year 1 ($50,000) is more than $15,000 greater than this average, the excess, or $30,000 is recaptured.

In this case, husband will have to pay tax on $30,000 in Year 3, and the wife will get a $30,000 deduction.

DON'T FIGHT OVER THE DEPENDENCY EXEMPTION IF IT WON'T DO YOU ANY GOOD

Although the dependency exemption decreases -- and is eventually eliminated at higher income levels, thereby making it useless to wealthier clients, many lawyers still fight over the exemption in the bargaining process and waste a lot of time and money.

And where the exemption isn't phased out, it still may not be worth the cost of a fight.

The exemption goes to the custodial parent unless he or she expressly waives it. (Form 8332 can be used for this purpose.)

THINK TWICE ABOUT FILING A JOINT RETURN

Except it very uncomplicated situations - such as when both spouses earn W-2 wages, filing a joint return while a divorce is in the works can be very dangerous because both spouses liable all taxes owed, interest, and penalties that may be due. This means that if one spouse does not report income or claims improper deductions or doesn't pay what's due, the other spouse who signs the return will be responsible for the liability. And sometimes, lawyers overrate the benefit of filing joint returns.

For example, assume that John and Jane sell their home before the divorce, realize $100,000 gain, and file a joint return, both telling the IRS they will roll the gain into a new home. Each takes $50,000. After they separate, John buys a new home within two years, but Jane does not and spends the money. Although Jane is obligated to pay the taxes on $50,000, since they filed a joint return and John has the assets, the IRS can go after John for the money because he was jointly and severally liable because he signed a joint return in the year of the sale.

Another item to think about: There may not be a large enough benefit to justify the risk of filing a joint return. For example, if Husband sells a business and incurs a $300,000 gain, why should Wife sign a joint return to save $8,000 or so in taxes? And unless one spouse has significant losses and deductions that can't be used unless they're applied to the other spouse's income, the tax savings just aren't very significant. In fact, a couple may actually pay less tax if they file separately and the spouse with the children files as "head of household."

If a divorcing couple files jointly, at a minimum, there should be an indemnification agreement - which is not binding on the taxing authorities and won't help if the signing spouse is not able to pay. There should be a provision that the indemnification is intended as a support provision so that there will be a chance that it is not discharged in bankruptcy.

Although an "innocent spouse" under the tax law is not responsible for the other spouse's under-reporting of income or improperly claimed deductions, to be entitled to "innocent spouse" status, a spouse must meet stringent burdens including lack of actual or constructive knowledge of the misdeed.

DON'T SETTLE YOUR CASE WITHOUT EXPERT TAX ADVICE

Good divorce lawyers recommend engaging a tax expert in any case that involves business or complicated property or support issues. Experts are especially useful when it comes to rearranging the ownership of a closely held business.

You can use a tax lawyer, a CPA, or in some instances, both. The tax lawyer is generally more likely to help with creative tax planning while accountants are generally more adept at valuing assets and predicting the tax consequences of agreements.

Although a tax expert needn't have special expertise in divorce tax, there is a growing list of experts who do nothing but divorce taxation. And this must extend to estate planning and pension issues.

Generally, a tax expert should be consulted whenever there is even a hit that one spouse has violated the tax laws.