3 Tips to Achieve a Tax-Smart Divorce
Divorce is expensive – time, energy, emotion, and of course, legal fees. And while transferring assets between spouses due to divorce does not generally result in a tax consequence, repositioning assets to create cash flow and a strategy to align with each spouse’s individual goals likely will.
Avoiding these three mistakes will enable both spouses to minimize Uncle Sam’s cut without needing to become a tax expert.
1. Be mindful of the tax structure of all assets
It pays to focus not just on the value of the assets being divided, but also on the underlying tax implications. The after-tax value is arguably more important to understand. Making tax-savvy divorce moves will increase the chances that both spouses will end up with more cash in their pockets in the end.
Here is an example:
John and Jane have two holdings of the same stock, each currently worth $100,000. On the surface, seems like an equal split makes sense. After all, they are each getting the same value of stock, right? Consider the following…
- One lot was bought when the price was low, and cost only $45,000. The second lot was bought much later, for $90,000. Which is more appealing?
- When the stock is sold, the first lot has an $11,000 tax bill – assuming the profit of $55,000 gets taxed at a 20% capital gains tax rate. The holder of the first lot keeps $89,000 after taxes.
- Contrast this with the second lot’s tax bill of only $2,000 on $10,000 profit at 20%. The holder of the second lot keeps substantially more after taxes – $98,000.
Moral of the story: when splitting assets, avoid a Titanic mistake by ensuring the focus is on the after-tax value of each asset.
2. Take “credit” where it’s due
Are kids’ part of the couple’s divorce equation? If yes, each spouse should think about not only the credit for being a great parent but also about the tax credits they may be entitled to from Uncle Sam.
Before 2018, when the new U.S. tax law went into effect, one parent could claim a “dependency exemption” of about $4,000 per child. This exemption reduced the amount of their taxable income. In a divorce, the person eligible to claim the dependency exemption is generally the “custodial parent” – i.e., usually the parent with whom the child spent more overnights.
The new tax law “zeroed out” the amount of that exemption, but only through 2025, when it’s scheduled to kick back into its pre-2018 form. Though the dependency exemption is $0 towards taxes today, it may still provide value in the future due to the following:
- The person entitled to the dependency exemption holds the keys to all other child-related tax benefits in the intervening years, provided their income isn’t too high to qualify. This includes the child tax credit, educational credit, earned income credit, and child-care credit.
- The exemption is scheduled to come back in 2026, so if the children are young make sure this valuable right is carefully considered.
If one spouse expects to make significantly less money post-divorce, consider parental responsibilities and the dependency exemption carefully to be sure the right decision is made regarding child-related items.
3. Don’t forget tax benefits from the marriage
Have a tax refund coming? Ensure the refund is put on the table as part of the settlement negotiation.
Is either spouse involved in a business or do they have losses from selling stocks or investments? If so, the couple may have some “loss carryforwards.” These are prior-year losses that the IRS allows to be used to reduce future taxable income, and future tax bills. In the heat of divorce negotiations, it’s easy to forget these amounts and let them slip. Be sure to track prior year returns to identify any carryforwards and include them in the settlement negotiation.
At the end of the day, having a smart team including an experienced divorce financial professional and attorney on your side goes a long way to getting you the most bang for your tax buck. With a team at work for you, you can focus on really enjoying the next chapter of your post-divorce life (and not all the hidden tax details!).
Our experienced BDF Team (equipped with 11 CPAs) and Divorce Practice Group (armed with 2 Certified Divorce Financial Analyst™ professionals) would be honored to help any friends or family navigating divorce. Email your wealth management team or TheNextChapter@bdfllc.com for more resources.
As a wealth manager, Kristina's passion is building strong relationships. She enjoys providing clients with financial peace of mind and empowering them to make sound financial decisions. She is an integral part of BDF's Divorce Practice Group where she helps divorcing individuals through all aspects of the divorce process and through the next chapter of their lives. Kristina also has a specialization in marital planning.