Tax Implications of Divorce for High Net Worth Individuals

Tax Implications of Divorce for High Net Worth Individuals.

No one wants to pay more taxes than they have to, or to pay taxes they don’t expect to pay. If you are not aware of the tax implications of divorce for high net worth individuals, an otherwise ideal divorce settlement could end up being a lot less ideal if the terms trigger an unexpected, substantial tax liability. Knowing what to watch for ahead of time, and who to turn to for help, is essential to keeping more of your assets and avoiding surprises after the divorce is over.

What High Net Worth Individuals Should Know about Divorce and Taxes

For most people, the tax implications of divorce are limited because divorce-related property transfers are considered non-taxable events except in limited circumstances. But if you have a high net worth consisting of certain types of assets going into your divorce, depending on how those assets are going to be allocated as a result of the divorce, the chances that your divorce and tax issues will overlap increases. There are several ways the IRS may become unexpectedly involved if you are not mindful about the terms of your property settlement, and the timing of when your judgment is entered.

Filing Taxes During Divorce

Tax questions should come up while discussing a possible settlement, not after the divorce is entered. For example: Should you file your taxes jointly with your spouse, separately, or as single or head of household in the current tax year? Whatever your marital status is on December 31st dictates whether you can file taxes as a married person versus head of household or single. There are many financial advantages to filing a joint tax return with your spouse: therefore, some people choose to finalize their divorce judgment in the next tax year. You may benefit from your spouse’s lower income level reducing your tax bracket, or get the benefit of claiming deductions or tax credits to which you otherwise would not have access.

However, one of the benefits of filing jointly – the ability to claim your children as dependents and receive a tax credit – does not apply to high net worth individuals. In 2024, the child tax credit only applies to households with a combined income of $112,500. If you are the family’s primary or sole wage earner and your income exceeds that level, you could financially benefit from filing separately and allowing your spouse to claim the children (this could reduce your child and/or spousal support obligations).

If you are filing your taxes jointly as married while the divorce is still pending, you should plan well in advance of April 15th with your attorney as to what will happen to any refund. The options include holding the refund in trust to cover expenses of the divorce, or assisting one party with paying off the other for an asset they couldn’t otherwise afford.

And if you and your spouse owe estimated quarterly taxes during the time the divorce is pending, be sure to consider how to allocate those tax payments in the final property settlement. For example, if only one party is required to pay estimated taxes, and both parties are sharing that party’s income for the period during which the estimated taxes are due, it may make sense to consider those payments gone forever. But if you and your spouse are each keeping your own paychecks at some point during the divorce, the spouse who paid estimated taxes on wages they are keeping for themselves may need to reimburse the other spouse for estimated taxes paid from joint funds.

Who Pays Taxes on Spousal Support?

It used to be that a person ordered to pay alimony or spousal support could offset some of the hit by deducting those payments from their income for tax purposes. The person receiving spousal support would be responsible for reporting the payments as income and paying taxes appropriately. However, as a result of the Tax Cut and Jobs Act of 2017, spousal support is no longer taxable to the payee or tax deductible for the payer. However, spousal support “guidelines” are now lower because of this.

If you are looking to modify a prior spousal support obligation, make sure to consider whether your prior obligation was taxable to the payee or not, and be aware that you can no longer deduct your spousal support obligation if it is modified after 12/31/2018. I

Now, neither child support nor alimony can be deducted by the paying spouse. This means the money used to make those payments may be taxed at a higher rate (tax bracket) based on the paying wage earner’s higher income. You may be able to offset this somewhat by entering a settlement agreement that allows the paying spouse to claim the children as dependents and receive the child tax credits, subject to the limits discussed above. Be sure to obtain the proper IRS forms required to transfer child dependency exemptions as needed.

Watch Out for Taxes in Divorce

You may also face tax implications depending on the property division in your divorce. Because many attorneys and even judges are not tax experts, many high net worth individuals end up agreeing to property settlement agreements only to discover they inadvertently triggered significant taxes in the process.

Capital Gains Taxes on Second Homes and Vacation Properties

High net worth individuals may own more real estate than just the marital home. Their property settlements may include selling those additional properties, or transferring them to one or the other spouse. However, the protections that prevent you from paying capital gains taxes on your primary residence may not apply to vacation homes, rental properties, or other real estate. In 2024, the cap on excluded capital gains is $250,000 ($500,000 if you file a joint return with your spouse), and applies only to your primary residence. So if your Judgment of Divorce orders you (or you and your spouse jointly) to sell a home that is not your primary residence or a home with more than the limit in equity, you will need to account for the resulting capital gains taxes. If you are going to make a secondary home into your primary residence, you should talk with a tax professional about how long you must reside there to gain the capital gains exclusion for primary residences.

Effect of Tax Basis of Stocks and Investment Accounts on Settlements

You may be concerned that transferring your stock or investment portfolios between spouses will alter their tax basis and trigger short or long term capital gains taxes. Generally, the transfer itself between the spouses will not trigger a taxable event: it is when the stock is sold that taxes will be incurred. And the tax bill will go to the spouse whose social security number is attached to the account from which the stock was sold. There may be exceptions for stock held in margin accounts: be sure to check with your accountant before transferring assets in such accounts to ensure the transfer is done so as not to trigger a taxable event.

Stock and investment portfolios should be transferred between spouses “in kind” so that each spouse ends up with stock of equivalent “cost basis”. The difference between the cost basis and the sale price is what determines the amount of tax, as well as how long the stock was held. By dividing equities “in kind,” each spouse will experience the same tax consequence had they each sold the same stock at the same time. In other words, nobody will get stuck with the low-basis stock (higher tax consequences) or the high-basis stock (lower tax consequences).

It is important to consider how that tax basis will impact the value of the stock assets when each party chooses to sell them. If the stocks were purchased within the past year, they may be subject to a higher short-term capital gain tax than accounts held for longer periods of time, which subjects the sale to lower long-term capital gains taxes. Often, stock trading decisions are made during the marriage either by one spouse or an account manager. If you are not that spouse, that means you may not know the full tax implications of liquidating your investments and unknowingly make poor decisions about your future spending capacity. It is wise to discuss any potential property settlement with your financial advisor or accountant before committing to its terms to ensure you know the true value of the assets you are awarded after the taxes are paid.

Accounting for Taxable Losses and Depreciation

High net income families are also more likely to have carryover losses from prior tax years as a result of:

  • Net operating losses from business assets
  • Decreasing investment values
  • Capital losses
  • Depreciation on rental properties, vehicles, equipment, and other substantial assets
  • Charitable contributions
  • “Alternative Minimum Tax” (AMT) credits

These carryover losses aren’t tangible, and are easily overlooked when negotiating a settlement agreement. However, they are marital assets and sometimes can add up to hundreds or thousands of dollars in tax relief over several years. Before finalizing your divorce settlement, you should be sure to investigate if your family has any carryover losses recorded in your past tax returns, and negotiate for an equitable division of those assets. There are specific rules the IRS applies to carryover losses depending on the nature of the loss, and the property to which they are tied. Once again, it is wise to discuss the tax implications of taxable losses and depreciation with your accountant as part of your divorce planning.

Get Help from a High Net Worth Divorce Lawyer Who Understands the Tax Implications of Your Settlement

The high-asset divorce lawyers at Nichols, Sacks, Slank, Sendelbach, Buiteweg & Solomon have handled hundreds of divorces since the firm was founded in 1994, and know how to navigate the tax implications that apply to high net worth individuals. We will work with you and an appropriate financial professionals needed to identify, quantify and minimize the potential tax consequences of your potential property division or settlement agreement. This has the potential of preserving more of your assets and income for you and your children. Call 724-994-3000 to schedule a consultation with one of our experienced Michigan divorce attorneys to discuss your marital estate, and the tax implications that may come from dividing it up.

Categories: High Asset Divorces