As I’ve previously discussed on this blog, taxation is relevant to divorces in three main categories. The first relates to support, including child support and alimony. The second is about property distribution, called equitable distribution in Massachusetts. The third relates to certain deductions, filing status, etc., all of which are relevant when filing income tax returns. This article focuses on the second category: taxation of property received through equitable distribution in a divorce.
Generally speaking, under the United States tax code, a transfer of property from an individual to a spouse or former spouse incident to a divorce is not considered a gain or loss to either party. Rather, any such transfer is treated as a gift under the federal income tax code. The reason that is relevant is not because there is tax at the time of transfer. There isn’t. It is relevant because in any future convenience of that property by the person who received it in the divorce, the tax basis to calculate tax associated with any gain or loss is based on the basis had by the person transferring the property.
Basic Tax Gain Example. I am admittedly using legal and tax jargon here, so this may all seem nonsensical. Let me use an example to better illustrate. Let’s talk about basis, gain, and loss for a minute. Forget about the divorce part for now. Let’s say you purchase a house for $1 million. Let’s say that property appreciates in value by $200,000, and you then sell it for $1.2 million. The basis in the property is the original $1 million. Therefore, the gain on the property is $200,000. It’s the $200,000 that is taxed, meaning that the seller pays taxes on the $200,000. I should note that am oversimplifying here and there are several other factors that may impact this tax calculation–for example, there may be an exemption if the property was a primary residence for two of the prior five years; or, there may be depreciation that would need to be accounted for if it was an investment property. I am just keeping it simple to teach the basic lesson.
Tax + Divorce Example. Now, let’s apply the same basic hypothetical to a divorce. Let’s say the husband purchased the $1 million property prior to the marriage. Later, the parties got married, and during the marriage the property increased in value by $200,000. The parties then divorce, and the wife receives the property ou right through the equitable distribution plan. (Let’s just pause for a moment to clarify a potential burning question: If the property was in the husband’s name prior to the marriage, is it possible that the wife would get it in a divorce? Yes, it is quite possible, because in Massachusetts, we use a very broad definition of marital property, including essentially everything you own. Given a certain set of circumstances, it is possible the wife would get this house.)
Back to the tax issue. In our hypothetical, the parties are divorced and the wife has the $1.2 million property. She just received it at the conclusion of the divorce. One month later, she decides to sell the property that she just received. Are the taxes based on the $1 million value or the $1.2 million value? Pursuant to the federal tax code, the wife will take the husband’s basis, and if she sells the property at $1.2 million, she will need to pay tax on the $200,000 gain. Obviously, not considering this factor when negotiating settlement would be a problem.
What other Tax Rules Apply in a Divorce? Now, we are talking about the federal tax code, so logically, there are many particulars and details to consider. The term “incident to divorce,” for example, has a whole body of case law defining it. There is also special treatment and case law when payments are made by third parties. There are special rules that apply to interest on installment payments into retirement distributions. We will discuss some of these and other articles on the website, but this article is designed to illustrate the basics and that we have done.
It goes without saying that devising an equitable distribution plan without considering the tax implications would be and unwise idea. So two would be starting that conversation without understanding the likely tax implications of your case. The best way to get a sense of what might happen in your case is to meet with an experienced divorce lawyer who understands the tax implications resulting from divorce. To schedule a free attorney consultation with our office, call 978-225-9030 during regular business hours or complete a contact form here and we will reach out to you at our earliest opportunity.