Based on questions from our readers, we will share with you -- this week and next -- some common taxation mistakes that you can avoid when you divorce:

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 in connection with the divorce process are not taxable events. This means that the spouse who transfers property to the other spouse is not required 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.

For example, Joe and Jane buy a piece of real estate during their marriage for $50,000, own it jointly, and the property is worth $100,000 at the time of their divorce. Because Jane wants to keep this property, 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 property later, she will pay capital gains taxes on every penny realized by her over the initial $50,000 purchase price.

This is one of the reasons to create a schedule of assets that includes property cost, value, and after-tax value. The 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 timberland, with the wife getting 80% of the proceeds and the husband 20%? Although many assume the husband will be liable for only 20% of the capital gains tax, they are wrong: 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, the husband will be liable for one-half of the tax, regardless of the size of his share.

Here are some ways to avoid this problem:

1. Divide the ownership of the property before the sale. In this example, the 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 his/her gain according to the division of the proceeds, this will work if both do what they promise. 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 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. However, where the exemption isn't phased out, it still may not be worth the cost of a fight. Generally speaking, the exemption goes to the custodial parent unless he or she expressly waives it.

Next Week: More Tax Issues and Answers