Breaking Up is Hard to Do - 3 Tax Tips to Help

By Michelle Petrowski Buonincontri, CFP, CDFA On 11/23/2021

“Breaking up is hard to do” as the song says.  And taxes and estate planning considerations are important parts of property division in divorce, especially when a couple has assets like Bill and Melinda Gates. Keep in mind, many times couples have a “pre” or “post” nuptial agreement that will guide this process and hopefully make it a bit easier on the folks involved, and having knowledge about assets (property

When dividing assets, we always want to try to compare apples to apples, and value assets on an after-tax basis in order to create equality.  Now, although I’m not purporting to know anything about Bill & Melinda’s specific situation, here are a few less thought of considerations for them and other non-Gates couples around dividing property in a divorce.

1. Tax considerations for rental properties:

  • Depreciation recapture - When assigning rental property during a division, depreciation recapture needs to be considered, as it reduces a property’s cost basis; potentially increasing taxes due at the sale and reducing net sale profits to the receiver of that asset. 
  • Loss of the capital gains exclusion – In general, if this property is sold immediately, none of the gain will qualify for the $250K(Single)/$500K (Married) capital gains exclusion because of IRS use rulesfurther reducing the actual asset value received by the taxed paid at the sale.  Additionally, if a rental is turned into a primary residence, the spouse receiving the property will need to live there for at least 2 out of the 5 years preceding the sale, so that some or all the capital gains exclusion may apply when the property is sold.  Losing the capital gains exclusion reduces the value of the property ultimately received by that spouse.  For the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule see Publication 523

2. Transfers of property incidence to divorce & taxes:

  • According to IRC 1041 - Transfers of property incidents to divorce generally do not have tax consequences (including gift tax) but there are 4 exceptions.
  • One of them, often not thought of as a “gift of future interest”A “gift of future Interest” does not qualify for the unlimited marital deduction, the annual gift exclusion ($15,000 in 2021), or the exclusion for gifts to spouses who are not US citizens ($159,000 in 2021).  So, make sure it’s a transfer of a “present interest.  If it’s not, applicable gift tax should be calculated as part of a negotiated transfer of a future interest.  Since this will be a cost/expense incurred to the transferor, perhaps the gift tax should be added to the value of the asset when finding an offset of equal value to give to the transferring spouse in exchange for the gift of a future interest.

 

Here's an example of a gift of future interest:

Christine gives Tom the house as part of a divorce and while she, the “owning/giving” spouse stays in the home as long as she lives.  This is a “gift of future interest” to Tom, not a present interest because Christine, the “owning/giving” spouse, has not given up control of the home until her death.

3. Business considerations:

A business can be declared a marital asset, and the tax status of a company as an S corporation can affect the value of the company due to the lack of corporate income taxes.

  • An asset appraisal is needed in addition to a business valuation because the depreciated building, physical property, and intellectual property on the balance sheet will be undervalued, and not reflect the asset's actual value.
  • When dealing with businesses, be aware of what type of business valuation is being used as it will impact the value being divided. Two typical methods of business valuation are fair market value and fair value.  “Minority shareholder” discount or “marketability” discount can decrease the final appraised value of the business using fair market value, so ensure your attorney understands whether they benefit or hurt your interest.
  • Examine and consider Net Operating Losses, as there is a tax value here that can be used to offset ordinary income at some point and reduce tax liability.  This is particularly valuable to those in higher tax brackets, looking to preserve and grow wealth. 
  • Review Retained Earnings for hidden assets, as this is one way to hide available income in a company.  Review personal expenses covered by the business when identifying actual available income for the family.  Personal expenses paid by the business should be added back to personal income for child support and spousal maintenance. For more information on this topic see How Can You Determine Self-employed-Business Income

There are plenty more tax considerations, so having the right professionals to consult with can make a difference in your long-term financial outlook after divorce.

Let’s face it, divorce is a difficult time. It can be long and complicated, even when there are little assets;  so be prepared legally, emotionally & financially.  Having information is key.  Make sure you are informed, have copies of financial statements, personal & business tax returns (including all schedules), and debts.

Both the IDFA (Institute for Divorce Financial Analysts) https://www.institutedfa.com/  and the ADFP  (Association of Divorce Financial Plannerswww.divorceandfinance.org/ can be resources for finding a CDFA™ (Certified Divorce Financial Analyst)  professional to support you during this time of transition. Consult a Certified Financial Planner for comprehensive advice on strategies that address your specific retirement planning needs; see www.CFP.net or www.oneconnect.net.

 

This article was originally published May 24, 2021, on “The Street”

Tagged with: Tax tips, estate planning, divorce, rental property