The unhappy truth about marriage is that about half1 of them end in divorce each year. Without strict planning, a divorce could have devastating consequences for your family. In our last article, we talked about the importance of reviewing beneficiary designations and considerations for dividing assets. In this article, we discuss divorce, taxes, and your estate plan.

DIVORCE, TAXES AND YOUR ESTATE PLAN

Fortunately, some good news does exist within the arena of divorce, and it comes from no other than the IRS. Here’s the benefit. The IRS generally does not consider the transfer of assets between divorcing spouses a taxable event. This includes cash that one spouse pays another as part of the divorce settlement. There are a few restrictions to this rule, but as long as you can demonstrate that you are divorcing for legitimate reasons not related to tax savings, you and your soon-to be ex could transfer cash and assets without fear of a tax gain or loss to either party. At least, not in the short-term future.

FILING STATUS

Couples whose divorce won’t be concluded by December 31 of a given year will have to make a difficult decision regarding the filing status they choose on their tax returns. Married filing separate is the most costly filing status available. That’s why, if you and your spouse can agree to it, you may want to continue filing jointly until your divorce is final. There are two notable exceptions to this rule, however.

  • Exception 1: You probably shouldn’t file jointly if your spouse has incurred taxes that he or she won’t be able to pay. By filing jointly, you assume liability for your spouse’s taxes as well as your own.
  • Exception 2: You may not want to file jointly if you suspect that your spouse isn’t fully disclosing income or is falsifying deductions. You may be held liable for your spouse’s tax liability, plus associated penalties.

WHO GETS THE CAPITAL GAINS?

Let’s assume that you and your spouse own stock that has appreciated substantially since you bought it. Purchased for $50,000 five years ago, the stock is now worth $100,000. If the two of you decide to sell the shares today, the gain would be $50,000, or the difference between your original investment and the selling price. If you decide you’d like to keep the stock, and pay your spouse $50,000 (half the current market value) for full ownership, your total investment becomes $75,000. However, if you sell the shares, the cost basis used to determine your capital gains taxes won’t be the $75,000 you’ve actually invested in the stock. Instead, the government will look at your original cost basis – $25,000 – and your spouse’s original cost basis – also $25,000 – and deem that your actual cost basis is just $50,000! Therefore, the $50,000 cash you paid your ex-spouse for the stock goes to him or her tax free, while you are left with a hefty capital gains tax.

WHICH ESTATE PLANNING STRATEGY IS BEST?

Fortunately, all the problems described above can be neatly countered with a well-designed tax and estate plan. If you already have an estate plan in place, your main concern will be having it updated as a result of the new changes that your divorce has introduced into your life.

For most, these estate planning issues are of greatest concern during a divorce:

  • Controlling to whom, when and how assets are divided today, and how they will be distributed after death.
  • Capturing every tax break available during the divorce transition.
  • Maintaining control and management of certain assets.
  • Renaming beneficiaries.

Here are three estate planning strategies that may help you achieve these objectives:

  • The Revocable Living Trust — This popular estate planning tool is unlike a Will in that it allows you to avoid probate which brings on potential delays, expenses and public exposure. Instead, upon your death, your designated successor trustee assumes responsibility for management and distribution of your assets, which are owned by your Revocable Living Trust. Your trustee will follow the directions you have provided in your trust documents, including when you want assets distributed, to whom and by what means.
  • The Children’s Trust — Another estate planning strategy popular among parents is the Children’s Trust. It allows you to set aside funds which may be used at a later time to pay for college education or purchase a first residence.
  • The Irrevocable Life Insurance Trust — The Irrevocable Life Insurance Trust, or ILIT, accomplishes several important objectives. First, it lets you remain in control of the distribution of your life insurance policy’s proceeds long after you’re gone. As with the Children’s Trust, the ILIT disperses policy proceeds to your beneficiaries when and how you want. Because the trustee of the ILIT is your designee, you also ensure the proceeds remain out of your ex-spouse’s reach.

If you or your child are currently facing a divorce, contact us today to schedule an Estate Plan Review meeting so that we can make sure your interests are protected.

1 https://www.apa.org/topics/divorce/ (Encyclopedia of Psychology)