Divorce and Taxes

Last spring I wrote about an obscure tax provision known as the “Innocent Spouse Rule” and the potential effect it can have on an Orange County divorce settlement. Needless to say, that is far from the only tax issue that can arise when one is contemplating a divorce. Recently, the Wall Street Journal’s Smart Money column offered some useful pointers on major (and, in most cases, more common) issues that also bear consideration.

While state law governs many aspects of divorce – such as the community property rules that apply here in California – many of the tax implications of a Los Angeles or Orange County divorce are ultimately federal in nature.

As the Journal outlines, a key tax aspect of divorce involves what are known as Tax-Free Transfer Rules. “The general rule is that you can divide up most assets… without any federal income or gift tax consequences,” the paper notes. If such transfers take place after the divorce becomes final, however, it is important that they be written into the settlement. If, for example, the settlement gives ownership of the house to one spouse but gives the other a share of any future sale price, that cash would come to the second spouse tax-free because the sale was made “pursuant to your divorce or separation agreement.” Similar, though often more complex, rules lay out specific treatment for stocks and bonds and for any capital gains realized from them.

The article warns, however, that tax advantaged retirement accounts (such as a 401K or 403B) are a very different matter. “You must jump through some hoops to get tax-free treatment if you transfer all or part of your account balances to your ex in divorce,” the article states. It also warns that IRAs are subject to yet another separate set of rules.

The lesson here is that a divorce’s complexities do not end with a basic agreement on the division of assets. An Orange County divorce attorney can help advise you on these complex situations – including letting you over whether your financial affairs are sufficiently complex that an accountant or other tax professional ought to become involved in the discussions.

Wall Street Journal/SmartMoney: What Divorce Means For Your Taxes