Divorce settlements can be extremely complicated. While it makes eminent sense to work with a financial advisor as you plan your finances for a divorce, there are several key areas that can hold promise of avoiding or at least minimizing taxes on a divorce settlement. Before diving into specifics, it helps to get an overview of how divorce is treated by federal tax policy. Consider working with a financial advisor if you’re facing the prospect of a divorce or are currently in the middle of it.
The biggest mistake divorcing spouses can make is being in the dark about finances. If your spouse has always handled all of the financial decisions in your household and you don’t have any information about you and your spouse’s income and assets, your spouse will have an unfair advantage over you when it comes time to settle the financial issues in your divorce.
Refusing to try mediation or arbitration
Mediation and arbitration are two types of alternative dispute resolution that divorcing couples can use to avoid the time, expense, and stress of litigating a divorce in court. These processes also allow each spouse to retain more control over outcomes and keep family matters private, instead of leaving matters up to a judge and allowing divorce details to enter public court records. If you can afford it, it is still a good idea for each spouse to hire their own attorney to look out for their best interests.
Selling primary residence
If you sell your residence as part of the divorce, you may still be able to avoid taxes on the first $500,000 of gain, as long as you meet a two-year ownership-and-use test. To claim this full exclusion, you should make sure to close on the sale before you finalize the divorce. But even if you don’t meet the full two-year residency test, sales after a divorce can still qualify for a reduced exclusion.
However, your spouse can buy you out of the house without triggering any capital gains. In this case your spouse pays you for your share of the home’s value, divorce law considers it a marital transfer. This allows you to effectively collect the home’s sale price without paying taxes on it.
Asset liquidation upon divorce
Sometimes it is necessary to liquidate an asset upon a divorce that will inevitably carry a tax consequence. In such a case, you can take a look with our financial advisor at how this additional reportable distribution affects a spouse’s tax rate in the year the distribution is taken after the divorce. Or sometimes it can make greater tax sense for spouses to remain married if they agree to liquidate and split assets for their divorce to take advantage of a lower overall tax bracket in filing a joint return.
If you’re still legally married at the end of the year, you can file a joint return or choose the married-filing-separately status if you want to keep your finances distinct from one another. Married-filing-separately is particularly useful for spouses who don’t want to take responsibility for each other’s debts and finances, and for situations where one spouse earns significantly more than the other.
You can also file as head of household and get the benefit of a bigger standard deduction and gentler tax brackets. This can only work if you lived apart from your spouse for the last six months of the year, file separate returns, had a dependent living with you for more than half of the year, and paid more than half of the upkeep for your home.