Divorce

There are about 1.1 million divorces each year in the United States, almost 50% of the number of marriages annually. The divorce rate for all married couples is about 20%. Divorce usually involves both emotional strain and significant financial considerations, including the custody of children, current and long-term support, housing needs, and the division of personal and real property. With proper planning, however, a divorce settlement can be structured to provide the most favorable tax treatment to both parties, in order to minimize taxes and maximize post-divorce assets and income.

Property Settlements: One of the first steps in the formulation of a property settlement is the development of an inventory of all assets and liabilities -- on both a pretax and aftertax basis. In general, a property transfer between spouses or former spouses incident to divorce is not taxed. The transfer is treated as a nontaxable gift and the tax basis carries over from the transferor spouse.

Property settlements should be carefully reviewed to ensure they are equitable to both parties. Although the fair market value of property may be equally distributed to spouses, there are financial risks as well as tax consequences associated with the transfer of each type of investment. For example, a speculative limited partnership interest could soon lose much of its value, while a money market fund or a bank certificate of deposit would retain its worth.

Tax consequences also can be significant. Consider the following chart showing assets of similar fair market value (FMV) with different cost bases, and the effect on net cash value to the spouses.

Description	Stock A	Stock B	Vacation Home
Pretax FMV	$200,000	$200,000	$200,000
Basis	$50,000	$100,000	$150,000
Gain	$150,000	$100,000	$50,000
Capital Gains Tax (2%)	$30,000	$20,000	$10,000
Net Cash Value to Spouse	$170,000	$180,000	$190,000

In the event that one spouse is expected to be in a lower tax bracket, a property settlement can be structured to take advantage of the tax savings created by having more gain ultimately taxed at the lower rate. The tax savings could be shared, increasing the aftertax net worth of both spouses.

Alimony: Alimony represents payments to a spouse (or a former spouse) pursuant to a divorce or separation agreement. It does not include voluntary payments made outside the agreement. To be considered alimony, payments must also:

Additional payments that can be considered alimony are medical insurance and other expenditures made on behalf of a former spouse under a divorce decree or separation agreement, including payments for mortgages, real estate taxes, insurance, utilities, and life insurance premiums. Not considered alimony, and therefore not deductible, are payments for child support, maintenance of the payor’s property, certain annuities, noncash property settlements, and the use of property (rent-free housing).

Alimony is deductible from the gross income of the spouse making the payment and included in the income of the spouse receiving the payment. The deduction for alimony creates an opportunity to shift income from a higher to a lower tax bracket spouse. Where the tax benefit to the alimony payor is greater than the tax cost of the alimony income to the recipient, the tax savings from alimony payments can be used to help equalize or structure a property settlement.

If alimony payments significantly decrease or terminate during the first 3 years of payments, both payor and payee could become subject to recapture rules. In such cases, the front-loading of payments is construed to be a property settlement disguised as alimony. Generally, if the alimony paid in the second or third year decreases by more than $15,000 from the prior year, both spouses will be subject to the recapture rules in the third year. Proper structuring of alimony payments is required to prevent such recapture.

Qualified Domestic Relations Order (QDRO): The importance of "future" assets such as pensions and retirement benefits are often overlooked by spouses during a divorce. In order for non-employee ex-spouses (or dependents) to receive an interest in their former spouses’ retirement benefits, they generally will need a QDRO. This is a judgment, decree, or court order that provides an ex-spouse or dependent with the right to receive benefits from a qualified retirement plan or tax-sheltered annuity. A QDRO specifies the amount of retirement benefits to be paid or rolled over to the participant spouse, former spouse, and children. Benefits are included in income of the spouse to whom they are paid, while benefits paid to children are generally taxable to the participant in the plan.

The ex-spouse receiving these benefits should consider the need for life and disability insurance for the payor spouse to ensure that these payments will continue. Also, the participant spouse and ex-spouse need to make sure that the company pension plan allows for the payment of survivor benefits to the ex-spouse (i.e., an unmarried individual).

Prenuptial Agreement: Under certain circumstances, such as intent to remarry after a divorce or death of a spouse, the use of a prenuptial agreement should be considered. Such an agreement can be used to preserve wealth for children from a prior marriage or to protect valuable assets brought to a marriage by one spouse. If there is no prenuptial agreement and there is disagreement over ownership of property in the divorce proceedings, state courts will determine ownership and property disposition issues.

Tax and financial planning for divorce is complex and only begins with the subjects discussed above. Your financial, tax, and legal advisors can provide additional information and should be consulted before any action is taken.

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	Navigating Divorce Personal Finance Advisor by Deloitte & Touche OnLine September 15, 1997