In the last issue, we discussed the importance of paying close attention to tax and financial planning in the face of a pending divorce. We discussed when legal fees are deductible, the importance of carefully deciding dependency deductions, filing status, support payments and other key concerns.

Too often, individuals going through a divorce are burned by tax and financial planning errors that only exacerbate the pain they feel during an already difficult time.

Your family home

One of the most painful—and costly—issues fought over in divorce proceedings is the family home. Aside from the emotions and memories tied to a home, your primary residence can be a fertile source for tax deductions and future tax-free gains.

There are lots of options for the family home. One spouse could buy out the other’s equity in the home and remain there with the children. Other separating couples prefer to sell the house and divide the proceeds. Regardless of your preferences, it’s important to keep in mind that some basic rules concerning transfer of your house incident to divorce.

Sale prior to divorce

If you and your spouse decide to sell your family home before the divorce is finalized, you may be eligible to exclude up to $500,000 of gain form your taxable income so long as other requirements of the exclusion are met. These requirements are that you have not used the exclusion in the past two years and at least one of you owned and both of you used—or at least one of you owned and one of you used, if under a divorce or separation agreement—the property as a principal residence for at least two of the previous five years ending on the sale or exchange date of the home. You must file jointly to gain this benefit, which often does not happen when people are contemplating divorce.

It is critical to discuss with each other whether and when to sell your home prior to obtaining the final divorce decree. There are reduced exclusion rates for other circumstances (for example, bona fide and well-documented health reasons may impact your ability to receive an exclusion rate of gain on the sale of your house (see related article).

Transfer incident to divorce

If you or your spouse sells or transfers the house to one another as part of your overall property settlement in divorce, the transfer occurs free from taxable gain or loss at the time of the transfer. These transactions occur without recognizable gains or losses, as far as the IRS is concerned. In other words, these are nontaxable events. For such transfers that are “incident to divorce,” as language taken from Internal Revenue Code (IRC) section 1041 refers to them, there is no reportable gain or loss.

Several factors must be met for this section of the IRC to apply. The transfer between spouses:

1) must take place within one year from “the cessation of the marriage,” or

2) must be related to the divorce because the transfer is required by the divorce or separation agreement and the transfer occurs within six years of the divorce.

The recipient spouse’s basis remains the same as the transferor spouse’s basis, regardless of whether the property appreciates or depreciates and regardless of whether the individual spouse originally paid for the property or acquired it in some other way (for example, by gift or inheritance). The rules governing IRC section 1041 apply in both community property and non-community property states.

Note that these rules are not applicable to cases in which (1) the recipient spouse is a nonresident alien and (2) the transfer of property is in trust, and the trust itself owes an amount greater than the basis of the property.

Retain house, but sell later

Be advised that when the recipient spouse later sells the house following the divorce, that spouse (or ex-spouse) will only be entitled to an exclusion of $250,000 if he or she does not file a joint return. Also, note that the spouse computes any gain on any subsequent sale of the home based on the transferring spouse’s basis in the property, rather than the value of the property when it was received. The cost basis in property is an important factor when computing taxable gain, when taken into account with selling price.

Retirement funds

These days, retirement accounts are one of the most valuable—and litigated—assets that are divided incident to a divorce. As IRC section 1041 applies to transfers of real estate, it also applies to transfers of another type of property—retirement plans.

Broadly speaking, pension plans—whether defined benefit or defined contribution and qualified or nonqualified—will be considered as assets that fall within the marital estate. The marital estate is subject to division by a family court judge and is composed of part of the couple’s individual retirement accounts (IRAs), stock options, and other savings vehicles. All items within the marital estate are valuated prior to division, and your retirement funds are no exception. Retirement plans are generally valued either based on their current value or the value of the future income stream they can provide.

Various rules apply to various plans. For example, distributions of IRAs incident to divorce come with their own rules. Ordinarily, IRA distributions are included in gross income. Tax law cares out a caveat for the transfer of an interest in an IRA if that transfer is made to a spouse pursuant to a written divorce or separation agreement. It is critical that the interest in an IRA be transferred properly to avoid the value of the interest transferred being includable in gross income of one or both spouses.

Your employer or your former spouse’s employer might be instructed by court to distribute retirement assets through a qualified domestic relation order (QDRO). These rules must be followed carefully to avoid immediate taxation and possible penalties.

Gift and estate tax issues

While married, coup-les enjoy the benefit of combined annual gift tax exclusions, worth $12,000 times two, or $24,000, for tax year 2006. While married, the couple can gift $24,000 to each recipient, for example, to each child, per year. Once divorced and prior to any remarriage, this and other marital tax benefits essentially evaporate, leaving each spouse with only $12,000 each per donee per year to gift. Heeding rules to minimize gift and estate taxes plays a large part in your long-term financial planning strategy. Call our office to help with your personal financial planning needs following divorce or when entering a new marriage.