While spousal support is no longer taxable at the federal level for new orders, there are plenty of other ways your clients can end up with a large tax bill after their divorce if they aren’t careful. Here are some of the main tax issues to lookout for:
• State tax on spousal support orders, and federal taxes on pre-2019 spousal support orders that are modified.
• Distributions from a qualified plan.
• Section 1031 property exchanges.
• Restricted stock units (RSUs) and other stock plans.
• Capital gains tax on the sale of a home.
Let’s dig deeper on each of these.
Taxing Spousal Support
The Tax Cuts & Jobs Act of 2017 resulted in a change in the federal tax law for new spousal support orders that were agreed upon after January 1, 2019. Going forward, this income is nontaxable to the recipient and is not a deduction for the payor. This law was changed so the IRS could tax the higher wage earner on their full earned income and therefore collect more tax monies. The resulting impact on support orders is a reduction in the amount paid as the net after-tax income available for support is reduced by the higher tax burden. This change in federal law, however, did not necessarily result in a change in state tax laws.
“As an advisor, you need to know what the tax laws are in your client’s state as they do not always follow the federal law.”
As an advisor, you need to know what the tax laws are in your client’s state as they do not always follow the federal law. In California, for example, spousal support is still taxable to the recipient and deductible to the payor. Therefore, it’s very important that this taxation inconsistency is not only a factor in the calculation of the order, but also in how it will be reported on each party’s tax return. In a state like California with a high state income tax rate, this can make a significant difference in what the recipient actually has to spend each month. It can also make for a very bad surprise on Tax Day (May 17 this year) if your client is a recipient and hasn’t been saving for this expense.
Most orders made after this date have specific wording about the tax treatment for the life of the order, including any future modifications. This should definitely be part of the settlement document for your client so that the agreed tax treatment is maintained. I have seen this tax debate between CPAs for each spouse turn into a very expensive legal battle that didn’t have to happen if the settlement had provided that level of detail regarding taxation.
It is also very important to keep the tax law in mind if there is a modification to spousal support orders that were originally made prior to January 1, 2019. In some cases, if support has gone to $0 at some point and is to be reinstated, the modified order could be considered a new order and will be subject to the new federal tax law. This will be an important point for both the payor and recipient to understand. It will also make your job as an advisor even more important from a cash flow planning point of view if the nature of that income stream or payment is changed.
Division and Distributions from Qualified Plans
A division of assets incident to divorce is not a taxable event…if done correctly. For example, 401k(s), IRAs and other qualified plans can be divided by a QDRO (qualified domestic relations order) or stipulation for IRAs, with no tax implications to either party. However, these divisions must be made as rollovers directly to another retirement account or they will be treated like any other distribution.
It’s also important to consider what will be done with the money in these accounts once they are divided. I sat in court with a client and watched as the judge awarded her the full balance of her spouse’s 401(k) account. While on the face of it, that might seem like a good thing, I knew that the entire account was going to eventually be liquidated to pay attorneys fees. And since the account would be in my client’s name, she would be responsible for the full tax burden if I didn’t intervene.
Luckily, I was able to convince both attorneys that this wasn’t the intended outcome and we agreed to a stipulation after the hearing to allocate the tax burden more equally. If I hadn’t been there, the issue likely wouldn’t have been discovered until tax prep time and there is no telling if my client’s attorney would have been able to negotiate that tax allocation on her behalf, especially if the divorce had been finalized. As an advisor, it’s our job to be looking into the future. With a divorce, that can be even more complex and impactful.
There is one other point that should also be kept in mind if your client might need access right away to the funds from the retirement account. If cash is taken at the first distribution, the 10% penalty is waived even if the client is younger than 59 ½. If the money is rolled first to an IRA and then the cash is taken, the waiver does not apply and the client will pay the penalty so it’s important to make sure the initial instructions are complete and accurate and reflect the client’s needs. There can be a partial distribution of cash and the remainder can be a rollover if the plan is given the appropriate information. This could save your client a significant amount of money and help with their immediate cash flow needs.
1031 Property Exchanges
A 1031 exchange, simply put, allows the owner of a property to defer the taxable capital gain by purchasing another similar property. This came up in a case I was involved in with a couple who owned a rental property that generated significant income. As part of the settlement, opposing counsel suggested my client didn’t need spousal support because the couple could sell the rental and she could take her basis to another investment property and generate significant rental income from that new property without paying any capital gains tax.
The problem with that scenario is that based on this tax law, the new property must be held in the same ownership structure that the prior property was owned under or the exchange isn’t valid. The couple owned the first property in the name of their trust. Since they were divorcing, that trust would no longer be valid and they certainly didn’t want to purchase the next property together. Had they owned the first property as joint tenants, this exchange would have been possible. One solution to this issue would be to change the ownership in the original property prior to completing the 1031 exchange, but in that particular case that was not an option. Luckily for my client, I was able to raise this issue and demonstrate the negative impact on her taxes of a failed 1031 exchange, as well as her need for spousal support based on their proposal.
Deferred Compensation Stock Plans
When a deferred compensation stock plan is part of a divorce, it is very important to analyze and understand the levels of taxation for both the employee and the non-employee spouse who may be awarded assets from the plan. Not only is there ordinary income tax at certain points in time — usually at award or vesting — there is also a potential capital gains tax when the assets are sold.
As an advisor, we must also be aware of the implications with respect to a division of these assets. In the many cases I have worked on that include deferred comp stock plans, I have never had a case where the non-employee spouse could actually take ownership of the stock plan assets under their own Social Security number even though they were awarded the assets in the divorce settlement. Because of the plan rules, the employee spouse has always had to sell the assets on behalf of the other spouse and then distribute the proceeds to them. This means the employee spouse is then fully taxed on that sale at their own tax rate. It is therefore very important that there is an agreed deduction from the proceeds to cover that tax burden.
These asset divisions must be done through a QDRO, just like for a qualified retirement plan. Since a QDRO is done by a separate attorney, most often the details aren’t determined in the original settlement and the asset is often simply represented by a one-line item that says “to be divided by QDRO.” The problem is a QDRO does not address the tax treatment or how the tax burden will be allocated; it is a relatively simple document that is just designed to give the plan administrator instructions on how to divide the plan assets.
This type of asset division provides another great opportunity for an advisor to add significant value by raising these potential tax issues and making sure they are negotiated during the settlement process. The details should be spelled out very clearly in the settlement agreement, especially since some of these awards go 10 or more years into the future. Otherwise the parties could end up back in court, paying additional attorney fees, just to get the assets that one party was already awarded and to properly allocate the tax liability to the income recipient.
Taxes on the Home Sale and the “2 of the 5” Rule
In order to claim the exemption from capital gains tax on the sale of a residence, the taxpayer must have ownership and use of the property for two of the last five years prior to sale. Those years don’t need to be consecutive, they are cumulative.
If the house is sold during the divorce process or shortly thereafter, each party can claim the $250K exemption on their portion of the proceeds, for a total of $500,000 from the total proceeds. If one party buys out the other, then the deduction in the future is only $250,000 total. But there is also another option that preserves the joint $500,000 exemption for longer than five years into the future.
If use of the house is awarded to one party and the agreed plan is to sell the house and split the proceeds in the future, say when the youngest child goes off to college, there is a way for both parties to meet the “2 of the last 5” rule. This is accomplished with specific wording in the settlement that is recognized by the IRS and essentially says both parties will continue to own the house for a period of time, but only one is occupying the home. This wording allows the non-occupant spouse to “use” the occupancy of the other spouse to meet the rule, and therefore both can claim the $250,000 exemption when the house is sold.
While it is not the role of a financial advisor to draft the legal document, it is important that we make sure this clause is not overlooked if the plan is for the parties to maintain ownership of the house and to sell it in the future. We will be helping to preserve a very valuable tax benefit for our client that would have a significant impact on their future financial plan. Not every attorney or mediator, especially those who don’t specialize in family law, will be aware of the value of these specific words in a settlement. It is yet another way for an advisor to be looking out for our divorcing clients in a way that has a significant financial impact.
My work in a divorce is always forward looking. The rest of the legal team is focused on the past and getting to an agreement in the present without thinking through the financial ramifications that may come in future years. As advisors, we provide an extremely valuable service to a divorcing client by looking into that future from a cash flow point of view and making sure very costly mistakes aren’t made in the present by others who don’t have our expertise.
Kathy Costas, a vice president, investment advisor and Certified Divorce Financial Analyst® (CDFA®) at EP Wealth Advisors in Westlake Village, Calif., specializes in working with men and women going through a divorce. She was appointed by the Institute for Divorce Financial Analysts as the chair of the Southern California chapter of the Divorce Alliance, a group for divorce professionals. She is also the leader of the Conejo Divorce Resources Professionals group. She can be reached at [email protected] or 424-323-3852.