The Tax Consequences of Divorce
Ordinarily, the transfer of property comes with some sort of tax consequences. Since divorces can involve a lot of property transfer, you might expect complicated taxes surrounding them. Fortunately, the IRS exempts from taxation most property exchanges that take place in a divorce; however, appreciated assets, like stocks, and retirement accounts both come with particular tax issues.
General Tax Rules
Section 1041 of the Internal Revenue Code governs transfers between spouses and transfers related to divorces. The law generally exempts transfers so long as the transfer happens prior to the finalization of the divorce. The code also excuses transfers made after the divorce, so long as they are “incident” to it. A transfer counts as incident when it occurs within one year of the end of the marriage, or within six years of the end of the marriage if the divorce agreement requires such a transfer.
Unlike most possession, assets that have appreciated in value, like stocks, can cause tax issues if a spouse transfers them during a divorce. While no one owes taxes when the spouse transfers the stock, taxes do come due when the recipient spouse decides to sell. Exactly how the IRS taxes the stock depends on how long the spouses held it. If they held it for more than a year between them, then the IRS taxes the appreciation as a capital gain. Note that the clock for the year begins to run when the first spouse purchases the stock, not when they transfer it in the divorce. This means that, after taxes, appreciated assets can be worth less than an equal amount of cash, since the recipient spouse will owe the capital gains tax when they decide to sell it.
Transferring retirement accounts like IRAs can also come with serious tax consequences if not done correctly because the IRS places a penalty tax on early withdrawals from IRA accounts. This means that a spouse who simply withdraws cash from their IRA, and then gives it to the other spouse will incur a 10 percent tax on the money that they give away. Fortunately, transfers of an IRA can qualify as tax free under section 1041. Assuming that the transfer occurs incident to a divorce, then the spouse can move their money into a new IRA account in the recipient spouse’s name in order to avoid the penalty tax.
Divorces can be challenging and complex to navigate on your own. Contact an experienced DuPage County divorce lawyer
today. Their knowledge can help you as you make your way through this difficult process.