One of the huge benefits of helping divorcing spouses to negotiate their own separation agreements is that they have a chance to prepare a property division that feels fair to each of them. In many cases, that means one spouse keeping more of one kind of asset — for example, the marital home — and the other spouse keeping more of another kind of asset — for example, retirement funds. To achieve fairness in this kind of trade-off, spouses may want to consider the tax consequences associated with different kinds of assets.
Example: Real Estate and IRA
Consider, for example, a divorce between a fictional couple, Larry and Susan, who intend to divide their marital estate equally (50/50) in their divorce. Larry wants to stay in the marital home, and Susan is willing to work with him to make that possible. The couple bought the home for $700,000, and they agree it now has a fair market value of $800,000. The outstanding mortgage on the home is $600,000, meaning there is about $200,000 in equity in the home. Larry can qualify for refinancing up to the amount of the outstanding mortgage, but not for the additional $100,000 he would need to pay Susan her half of the equity.
To make Susan "whole" in the property division, one option would be for Susan to keep a greater share of the couple's retirement assets. In this example, let's suppose that Larry has about $300,000 in a traditional IRA. (For this exercise, we'll ignore any other assets that the couple might be dividing.) Between the $200,000 in home equity and $300,000 in the IRA, there is a combined $500,000 to be divided. Simple math suggests that this could be done by giving Susan $250,000 of the IRA.
Not so fast.
Under current tax law, after satisfying certain basic requirements, an individual selling their home does not have to pay taxes on the first $250,000 of gains. Because Larry and Susan bought the home for $700,000 and it's now worth $800,000, the gains from a sale would be $100,000, well below the $250,000 threshold. It might actually be less, if the couple invested in improvements that raised their cost basis in the home. So, that $200,000 in equity would not be taxed if Larry sold the home — although there would likely be a broker's fee associated with the sale, which the couple might also want to take into account.
In contrast, with some exceptions, withdrawals from traditional IRAs are subject to state and federal tax, plus an additional 10% penalty if the withrawal comes before age 59 1/2. This means that the post-tax, or "tax-affected" value of a $250,000 share of the IRA is not $250,000 — it's $250,000 minus the applicable taxes.
In this situation, if Larry and Susan are intent on achieving as close to a 50/50 division as possible, they may want to consider the tax-affected value of each asset. For the home, that might mean $200,000 minus a hypothetical broker's fee, and for the IRA, that might mean $300,000 minus applicable state and federal taxes. If they want to take this approach, they would be well-advised to conduct an informed tax analysis of their various assets — perhaps even with the assistance of a CPA — for the purpose of achieving a fair, tax-affected property division.
What if they can't agree?
If a couple can't reach an agreement on property division, they may find themselves asking a judge to decide. In Massachusetts, current case law requires family court judges to consider the tax consequences of property division, if a tax analysis is presented for consideration. An informal poll of Massachusetts family law litigators confirms that judges are indeed doing so, and one lawyer went so far as to state that if a divorce attorney is not "ready to explain the tax consequences to a judge ... they better be ready to explain them to their malpractice carrier down the road."
However, that doesn't mean a judge would divide the property in the manner described above, even if presented with a detailed tax analysis. Some judges are reluctant to muddy the financial waters, and would rather simply order the house sold. In that scenario, Larry and Susan would divide the net proceeds from the sale equally, and then divide the IRA equally. This would avoid any concerns about the tax consequences associated with each type of asset — but neither of them would get to keep the house!
This example underscores one of the substantial pitfalls of litigated divorce: it can (and often does) result in an outcome that neither spouse really likes. Alternatives to litigation, including mediation and collaborative divorce, afford the spouses an opportunity to talk through the finances of their separation and reach an agreement that bothof them are comfortable signing onto.