Avoiding Some Unwelcome Tax Surprises

February 1, 2015

Surprises are nice on your birthday, Christmas and April Fools’ Day. But they are not so welcome when you find out, post-divorce, that they result in a hefty tax bill. A pre-tax settlement can look very different from a post-tax settlement if consideration is not given to such issues as cost basis and depreciation. You can help your client make wise decisions by keeping some tax issues in mind during the divorce proceedings.

Capital Gains: Investments such as rental real estate, or stocks, bonds and mutual funds that are in taxable investment accounts are subject to capital gains tax if sold at a profit. (Likewise if sold for a loss the owner has a capital loss, which is deductible against other income.) Most investment gains are taxed at 15% but those with income in the highest bracket pay 20%. In addition some collectibles such as artwork are taxed at 20%. That means quite a chunk of the investment can be lost to taxes. Don’t be caught by surprise here – insist on knowing the cost basis (the total cost of the asset) before agreeing to accept the asset. Either split each asset exactly in half, or negotiate the split based on the after-tax value.

Depreciation Recapture: The IRS requires owners of investment property to expense the item over a specific time period. For instance investment real estate is depreciated over 27.5 years (this pertains to the building, not the land.) Depreciation is a nice perk because it’s a deduction that wasn’t actually an expense – the owner didn’t have to lay out any money to receive that deduction on the tax return. However the IRS gets all that depreciation back when the property is sold by taxing the accumulated amount at 25%. Here’s an example of how depreciation works:

Jason and Heidi own a ski condo that they rent out. They purchased the condo for $412,500. Therefore they deducted $15,000 per year in depreciation. After 10 years Jason divorces Heidi and keeps the condo. The day after the divorce he sells it for $500,000. Jason would owe capital gains tax on the gain of $87,500. He was probably aware of the concept of capital gains and ready for that tax hit. But he also owes 25% tax on 10 years of depreciation ($150,000). Ouch! That’s $37,500 in taxes he may not have expected.

Passive Losses: Some investment property owners have losses that they cannot deduct on their return. These losses are accumulated and are deductible when the property is sold. That makes the property more valuable than it appears, and should be taken into consideration when the property is allotted to one of the spouses.

Rental property converted to a personal residence: If a couple owns a primary residence and an investment property, one of them may reclaim the investment home as their residence after the divorce. Normally a homeowner receives a big tax break when they sell their personal residence – as long as they have lived in the property for 2 of the previous 5 years the first $250,000 of appreciation ($500,000 if married) is exempt from capital gains tax when the property is sold. But the entire exclusion may not be available when reconverting a rental property. That is because any period of time that the property was rented after December 31, 2008 is factored into the capital gains exclusion, even if the owner lives in it for 5 years as a personal residence. Thus the homeowner will never be eligible for the full exclusion. That may cause the owner to have a taxable gain.

The examples above highlight the need for financial planning during the divorce. You can help your clients to negotiate a settlement that is fully understood and has no ugly surprises in store.

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