Tax Issues in Divorce Cases: Property Division, IRS Liability, and Asset Basis

Why Tax Issues Matter in Divorce

Tax issues are frequently overlooked in divorce litigation. Parties often focus on custody disputes and dividing assets, but the tax consequences of those decisions can dramatically alter the true economic outcome of the divorce.

This article discusses three very important tax issues that arise in a divorce case and are easy to overlook:

(1) The importance of basis in the division of assets;

(2) The importance of a retroactive partition under Texas Family Code §7.002(c); and

(3) Division of tax liability and tax refunds and enforcement of same.

Tax Basis and Property Division in Divorce

(1) The importance of basis in the division of assets

Basis should not be ignored.

Asset inventories usually list fair market values and equity in marital assets, but leave out critical basis information.

Although the division of assets and divorce itself is not a taxable event, at some point in the future, one of the parties may sell the assets awarded to them in the divorce decree and have to face the tax consequences.

For illustration purposes, see Attachment 1 and assume the following:

The wife gets 1, 5 & 6 with an equity value of $975,000.

The husband gets 2, 3, 4, 7, 8 & 9 with an equity value of $970,000.

(For simplicity, assume the remaining difference is equalized through other property or a cash payment.)

Under Internal Revenue Code §1041, transfers of property between spouses incident to divorce are generally non-taxable, and the receiving spouse takes a carryover basis in the property. As a result, tax consequences are often deferred until the property is later sold.

• Retirement Funds – Distributions from retirement accounts such as 401(k)s and traditional IRAs are generally taxed as ordinary income, which may be as high as the 37% federal income tax bracket. They may also have a 10% early withdrawal penalty.
• Marital Residence – Gain on the sale of a principal residence is generally taxed at long-term capital gains rates, but up to $250,000 of gain may be excluded under Internal Revenue Code §121, if the ex-wife sells the home after the divorce and files as a single taxpayer in the year of sale. Up to $500,000 of gain could have been excluded if the home had been sold before the divorce while the spouses were eligible to file married filing jointly. Note that under Treasury Regulation 1.121-4(b)(2), a divorced spouse may still qualify for the $500,000 exclusion if the sale occurs pursuant to the divorce decree and the ownership and use requirements were satisfied during the marriage.
• Rental Property – Gain on the sale of rental real estate is generally taxed at long-term capital gains rates, with no exclusion similar to §121. In addition, the portion of the gain attributable to prior depreciation deductions may be subject to depreciation recapture, which can be taxed at rates up to 25%.
• Jewelry – Gain on the sale of jewelry is generally treated as capital gain. However, if the jewelry is considered a collectible, the maximum federal tax rate on long-term gain can be as high as 28%, rather than the usual 20% capital gains rate.

To see an illustration of the after-tax consequences of this division of assets, see Tax Balance Sheet Example in Attachment 2.

(2) Termination of Community Property

If the divorce becomes final before December 31, each of the former spouses is considered unmarried for federal filing status purposes and must file as Single or Head of Household, as applicable.

However, community property rules still apply to income earned before the divorce date. Unless the community property regime is terminated earlier, each former spouse must generally report one-half of the community income earned prior to the divorce.

The “single” filing status confuses people and they often report solely their income for the year of divorce and none of their former spouse’s income. This is a mistake. For the portion of the year they were married, they should report one-half of the community income, which includes the income of both spouses.

There is an easy fix to avoid this confusion. Texas Family Code §7.002(c) allows income earned during the year of divorce to be treated as separate property, thus avoiding community allocation rules. This statute allows retroactive partitioning of income and earnings from the spouses' property, wages, salaries, and other forms of compensation as of January 1 of the year of divorce. If there is a provision in the divorce decree that applies §7.002(c), each party can report solely their own income, deductions and credits, etc., for the tax year of the divorce.

(3) Division of tax liability and tax refunds and enforcement of same.

In many divorces, it may be appropriate to allocate responsibility for unpaid taxes disproportionately between the parties. For example, one spouse may be a W-2 employee whose wages were subject to withholding, while the other spouse may be a self-employed contractor who failed to make required quarterly estimated tax payments. In such a situation, it may be equitable to allocate a larger share of the unpaid tax liability to the spouse whose income generated the deficiency.

Similarly, one spouse may operate a business that underreported income or claimed aggressive deductions. When this occurs, the divorce decree may designate which party will bear the risk of any additional tax assessments arising from those positions.

The parties may also wish to address the allocation of potential refunds for prior years. For instance, a refund could arise if a spouse later generates a net operating loss or business credit that can be carried back to earlier tax years. In such cases, the decree may specify which party is entitled to those refunds. However, note that under current law, most net operating losses cannot be carried back and may only be carried forward (with very limited exceptions).

Before finalizing a divorce settlement, it is often advisable to conduct a basic IRS compliance check. This can reveal unfiled returns, outstanding balances, and in some cases, pending audits or examinations that might otherwise go unnoticed.

Importantly, even if a divorce decree allocates responsibility for tax liabilities to one spouse, that allocation is not binding on the IRS. If a joint return was filed, both spouses remain jointly and severally liable for the tax under federal law. As a result, the IRS may pursue either spouse for the full amount of the liability, regardless of what the divorce decree provides.

In practice, this creates a significant risk. Our firm has represented numerous individuals who were pursued by IRS collections for liabilities that a divorce decree required their former spouse to pay. To mitigate this risk, any obligation for one spouse to pay tax liabilities should, when possible, be secured—such as by granting a lien on property awarded to that spouse (referred to as an “owelty lien” or, more broadly, a lien to secure assumption of a debt) or by using other financial protections in the settlement agreement.

There may be remedies available for the ‘innocent spouse’ in this case through IRS procedures, but it will be a long and frustrating process that may have been avoidable.

Key Tax Issues to Consider Before Finalizing a Divorce

This article is not intended to cover all the tax issues that may arise in a divorce, but only three of the most common and most painful issues that should not be ignored:

(1) The importance of basis in the division of assets;

(2) The importance of a retroactive partition under Texas Family Code §7.002(c); and

(3) Division of tax liability and tax refunds and enforcement of same.

We hope this article has given you a glimpse of the necessity of having a tax professional involved in a divorce case, particularly in drafting the divorce decree.

Example Asset Division and Tax Basis in Divorce

Attachment 1

After-Tax Balance Sheet Example in Divorce Property Division

Attachment 2

After-Tax Balance Sheet Example

Wife’s Assets

Total After-Tax Value: $901,190

Husband’s Assets

* This estimate assumes long-term capital gains rates. In practice, part of the gain from the sale of rental real estate may be attributable to depreciation recapture, which can be taxed at rates up to 25%, potentially increasing the tax liability.

Total After-Tax Value: $746,650