Getting Divorced? Avoid These 2 Tax Traps

The lead attorney in a family law practice recently said to me, “You know, in my business, none of the participants ever has more at the end. Nobody gets divorced and winds up with more assets.” That got me thinking: Could there be such a thing as a tax-efficient divorce?

In a traditional sense, tax-reduction strategies are usually put in place to minimize the tax impact associated with assets changing hands. This often comes into play when a business is being sold or when appreciated real estate is being liquidated for owner health reasons or estate planning.

If we approached the tax implications associated with divorce with the same discipline as any other transfer of assets, we could discover tax-saving opportunities that both parties could agree on. Here are two divorce tax traps to avoid and the opportunities that could provide tax-saving solutions.

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1. Alimony Paid Is No Longer Tax Deductible for the Payor

One of my attorney friends often expresses concern about how the ever-evolving laws on alimony taxation can add additional pressure on negotiations between parties. Starting in 2019, alimony-paying spouses can no longer deduct these payments. (Note: The new rule applies to any divorce finalized after Dec. 31, 2018. The old rule still applies to divorces settled before then, meaning the payor can deduct payments and the recipient must pay tax on them.)

The result of the new rule? In many situations, the spouse with the higher income is increasingly motivated to minimize those payments.

This additional pressure extends to every other area of a divorce settlement, and the removal of this “tax subsidy” in 2019 is a huge factor in settlements. The burden of higher-than-anticipated alimony can often force the higher-income spouse to liquidate some of their assets. This, in turn, can trigger even more taxes in the form of capital gains, perhaps extending the sell-tax-sell cycle even further. This sequence can be perpetuated by unusual cash-flow pressures created by legal fees and the establishment of a new, second dwelling for the family that now requires two homes instead of one, among other factors.

In cases like this, advanced structures like recently introduced Opportunity Zone compliant Investment Funds can defer such gains until 2026, and in some cases can make the future gains on dollars invested tax free over the following ten years. (For more, see Opportunity Zone Investing: Is It for You?) While that doesn’t completely mitigate the tax, it certainly can provide meaningful offsetting resources down the road, potentially as much or more than the original tax.

In a case where ordinary income exceeds $1 million, other mitigation tools come into play that can often reduce tax bills by 5% to 10% of gross income, freeing up cash for other current needs. These tools rely on partnerships that consider the potential donation of real estate, in lieu of development, that can create a large one-time charitable deduction that otherwise would not be available.

2. Appreciated Income-Producing Real Estate Can Greatly Impact Taxation & Income Calculations in Divorce Settlements

Take a couple who owns an apartment complex worth $6 million that generates $15,000 per month in net free cash flow. While the wife is comfortable managing the property, and even enjoys it, the husband doesn’t have the requisite time or patience for such things. It is also important to them to not continue owning property together, even with a divided interest. The property is long paid off and if it is sold, the capital gains tax would be approximately $1.2 million, leaving the couple with only $4.8 million combined to invest.

By structuring a portfolio with 1031 compatible DST (Delaware Statutory Trust) funds, the property can be sold, and the full amount of equity can be transferred to the new funds tax deferred, enabling the entire $6 million to be invested. In this example, the potential yield on the new funds might average 5%, so an immediate monthly income of $25,000 could be generated. The new portfolios are geographically diverse, tenants span a variety of industries, and the funds are institutionally managed.

These assets now sit on a financial statement and require no hands-on management. Real estate tax advantages and investment attributes are maintained, capital gains taxes are deferred, and the opportunity for stepped up basis is preserved. Depending on the titling of the existing property, income agreements could also be funded by the assets. Best of all, the parties can go their separate ways without losing the income or triggering the tax, and can even achieve an upgrade in quality and diversification. Perhaps most interestingly, the wife enjoys more income than before without having the property management duties and frees up much-needed time to return to law school, something she had given up years prior in favor of her husband's career.

The Bottom Line

While divorce will always be difficult, it can help to use the most advanced tools available to lessen the financial burden. Although we might never equate divorce with selling a business, it is quite true that the tax impact can be very similar - so why not utilize the same tools?

The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax, or legal adviser with regard to your individual situation.