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Steering Clear of Financial Landmines in Divorce

By Andrew K. Hoffman on January 31, 2013

Understanding the financial and tax implications of your options – and avoiding financial landmines – is critical in creating a settlement that will last long-term

When negotiating your financial settlement, you need to know and understand the facts and your options before finalizing your settlement. In my divorce practice, I have found some crucial items are often overlooked; this article outlines some of those items for your consideration. Make sure to work with your lawyer and a divorce financial professional to cover the bases.

Take Taxes into Account

Failing to understand the tax basis of property can generate unexpected taxes for the spouse receiving property, which reduces the value of the settlement. Carefully reviewing the tax basis of all property, and planning whether to keep or sell the property post-divorce, can avoid the problem of unanticipated taxes on unrealized gains.

Dividing marital property into tax assets of similar tax basis, and then dividing these classes equitably, helps to avoid the complexities or omission of offsetting assets with different basis.

Review Tax Returns

Personal tax returns are a financial road map to the finances of the family and vital to arriving at a financial settlement. With the current downturn in the economy, loss carryforwards are appearing on more tax returns. Carryforwards have a value as a potential tax benefit; some can be deducted from future income, and others affect the basis of the transferred property.

Be sure to negotiate how unused capital losses, net operating losses, passive activity losses, charitable contribution carryforwards, and unused investment interest expenses will be divided in your settlement.

Understand Retirement Plans

Not all retirement plans are the same. It’s crucial to find out what options are available to you, and to make sure your divorce agreement only includes payments that your – or your spouse’s – plan allows. Here are three points to consider:

  • Defined Contribution Plans: Find out whether your particular plan will allow distributions. This is an important consideration if some of the retirement funds will be used to generate liquidity, or rolled over to another retirement plan. Some plans do not allow distributions on certain investment choices, while other plans have temporarily frozen funds in certain investment choices. Because of the downturn in the economy, the timing of the distribution also matters; choosing the right timing of a distribution can help one or both spouses reduce or avoid unanticipated taxes.
  • Defined Benefit Pension Plans: Understanding whether there will be a lump-sum or a future stream of income available from the plan helps couples negotiate better settlements. It might be better to value the pension and offset the value with other assets, divide the future income, or combine these two approaches.
  • Survivor Benefits: Understanding the importance of survivor benefits and making sure they are included in the pension division document ensures that the spouse who is not directly participating in the plan doesn’t lose their pension rights if their ex-spouse dies before them.

Short-Sales May Result in Taxable Income

In depressed housing markets, where many homes are worth less than the mortgage balance, some homeowners are negotiating with their banks to make a short-sale. Understanding whether a short-sale could result in a taxable gain and whether any taxes would be payable on the sale is another important minefield that has to be navigated.

Structure Spousal Support Carefully

Spousal support can be used to shift income from the spouse in a higher tax bracket to the spouse in a lower tax bracket (it reduces income to the payor and increases income to the recipient).

Be sure to structure your spousal support properly so you don’t trigger unanticipated taxes. Avoid:

  1. Front-end loading of spousal support in the first three years after a divorce.
  2. Reducing spousal support based on a contingency related to your children.

A mistake in either of these areas may cause the payor spouse to lose all or a part of the spousal support deducted on his or her tax return and be charged not only unexpected taxes but also penalties and interest. This is an extremely complicated area; ask your divorce financial professional to explain it to you to avoid an expensive surprise from the taxman down the road.

Check your Health Coverage

In the USA, the Consolidated Omnibus Budget Reconciliation Act (COBRA) contains provisions giving certain former spouses the right to temporary continuation of health coverage at 102% of the actual employer’s premium. In order to be eligible for continued coverage, you must inform the ex-spouse’s employer of the divorce within 60 days of the divorce. Trying to cover an ex-spouse by not informing the employer of the divorce can result in health coverage being denied or a fraud lawsuit by an insurance company attempting to collect medical benefits paid.

[Ed. In Canada, extended health-care plans will not cover an ex-spouse post-divorce; once divorced, a spouse no longer qualifies as a dependent. If you’re the non-member spouse, and if you have documented medical issues, you need to investigate plans that allow for pre-existing conditions ASAP; most plans of this type need to be placed within 30 days of the divorce, so time is of the essence here.]

With offices in Arizona and Louisiana, Andrew K. Hoffman has practiced as a CDFA® since 1999. He is chairman of the Institute for Divorce Financial Analysts’ (IDFA) Editorial Committee and a member of the IDFA Advisory Steering Committee. His firm’s website is lacdfa.com.