What tax issues should be considered before accepting a divorce settlement?

Why after-tax value matters more than face value

The most important tax concept in divorce is that the dollar value on a statement is not the amount you'll actually have after taxes. A $100,000 brokerage account with a low basis and a $100,000 savings account are not equal - the brokerage account will trigger capital gains tax when sold, reducing the actual amount you receive.

The key tax issues to review

Tax basis and capital gains

Every asset has a tax basis - what you paid for it (or what it was worth when you acquired it). When you sell, you pay capital gains tax on the difference between the sale price and the basis.

• Low-basis assets - assets that have appreciated significantly will have a large tax bill when sold
• High-basis assets - assets that haven't appreciated much have minimal tax consequences

In a divorce, the spouse who receives a low-basis asset is also receiving the future tax bill.

Retirement accounts: pre-tax vs. Roth

• Traditional 401(k) and IRA - pre-tax contributions, taxed as ordinary income upon withdrawal. The full balance is taxable.
• Roth 401(k) and Roth IRA - after-tax contributions, tax-free withdrawals. The full balance is tax-free.

A $200,000 traditional IRA is worth less after taxes than a $200,000 Roth IRA.

The marital home and capital gains

Selling a marital home can trigger capital gains tax, but the primary residence exclusion (Section 121) allows you to exclude up to $250,000 of gain (or $500,000 if married filing jointly) if you've lived in the home for 2 of the last 5 years.

After a divorce, the exclusion drops to $250,000 for a single filer. If the home has appreciated more than $250,000 above the basis, selling can trigger a significant tax bill.

Alimony tax treatment

The tax treatment of alimony depends on when the divorce was finalized:

• Divorces finalized before January 1, 2019 - alimony is deductible by the payer and taxable to the recipient
• Divorces finalized on or after January 1, 2019 - alimony is not deductible by the payer and not taxable to the recipient (per the Tax Cuts and Jobs Act of 2017)

This distinction affects both the payer's and recipient's after-tax income and should be factored into any support analysis.

Transferring appreciated assets

When assets are transferred between spouses as part of a divorce, the transfer itself is generally tax-free (Section 1041). But the receiving spouse takes the same tax basis as the transferring spouse - meaning they inherit the future tax bill.

Estimated taxes and withholding

After a divorce, your tax filing status changes from married to single (or head of household). This can change your tax bracket, your withholding, and your estimated tax payments. If you receive a large retirement account distribution, you may need to make estimated tax payments to avoid penalties.

How to compare assets on an after-tax basis

1. List every asset and its current market value
2. Determine the tax basis of each asset
3. Calculate the estimated tax upon sale or withdrawal
4. Subtract the tax from the market value to get the after-tax value
5. Compare after-tax values, not face values

Factors that typically matter

• Tax basis of each asset - determines the capital gains tax when sold
• Pre-tax vs. Roth retirement accounts - traditional accounts are fully taxable, Roth accounts are tax-free
• Capital gains on the marital home - the $250,000 single-filer exclusion may not cover large gains
• Alimony tax treatment - depends on when the divorce was finalized
• Filing status change - moving from married to single can change your tax bracket
• Transfer basis - the receiving spouse inherits the original basis, not a stepped-up basis
• Estimated tax obligations - large distributions may require estimated payments
• State tax considerations - Utah has a flat income tax rate that applies to all income

Documents commonly reviewed

• Tax returns - 3–5 years, to identify income, basis, and prior capital gains
• Brokerage statements - showing cost basis and unrealized gains
• Retirement account statements - distinguishing traditional vs. Roth
• Mortgage statements and closing documents - showing the home's purchase price and basis
• Home appraisal - current market value for capital gains calculation
• Investment cost basis reports - from your broker or financial institution
• Prior year tax filings - to estimate effective tax rates

Common mistakes and misconceptions

• Comparing face values instead of after-tax values - the most common and most expensive mistake
• Ignoring tax basis - the spouse who receives a low-basis asset inherits the future tax bill
• Not distinguishing pre-tax from Roth - a traditional IRA and a Roth IRA with the same balance are not equal
• Overlooking the home exclusion change - after divorce, the exclusion drops from $500,000 to $250,000
• Not planning for estimated taxes - a large distribution can trigger underpayment penalties
• Forgetting about state taxes - Utah's flat income tax applies to retirement withdrawals and capital gains
• Not factoring alimony tax treatment - the pre-2019 vs. post-2018 distinction affects both parties

When a professional may be useful

A CDFA® or tax professional can help by:

• Calculating the after-tax value of every asset in the settlement
• Identifying the tax basis of investment and real estate assets
• Distinguishing pre-tax from Roth retirement accounts
• Modeling the capital gains impact of selling the marital home
• Factoring alimony tax treatment into the support analysis
• Projecting the long-term tax impact of the settlement over 5, 10, and 20 years
• Coordinating with your attorney and tax advisor to ensure the settlement is tax-optimized

Davis Schuler & Associates includes tax analysis as part of our divorce financial analysis services. We are Enrolled Agents (EA) and can represent clients before the IRS.