Understanding the financial implications of divorce before the divorce asset negotiations begin can make an extremely emotionally difficult situation easier to navigate.
6 issues to consider during divorce asset negotiations.
1) Understand the tax implications of each asset
As each party negotiates dividing the marital assets, one of the biggest mistakes is not considering the tax consequences of each asset. For example, $1000 in a bank account is not the same as $1000 in an IRA, given that a withdrawal from an IRA would be taxed at ordinary income tax rates and possibly a 10% early withdrawal penalty, while the cash withdrawals wouldn’t be taxed. Likewise, $1000 in brokerage assets would likely be less valuable than $1,000 in a bank account, since the brokerage assets could have a cost basis much lower than $1,000 as it would be subject to capital gain taxes.
It’s important to analyze each asset and take into account the tax consequences of the asset so you can view the investments apples to apples as you’re negotiating the settlement. Keep in mind that transfers between former spouses aren’t taxable since IRS Section 1041 allows transfers to be tax-free between former spouses within one year of finalizing a divorce or within six years if it’s spelled out in the divorce agreement.
2) Carefully address unique assets in negotiations
There is a whole host of other division of asset issues that trip up divorcing couples, and being aware of them before the divorce settlement is finalized can save headaches down the road. Private investments are particularly troublesome since stock in privately held businesses is typically difficult to value and even harder to convert into cash. A lot of attention and analysis should be paid to dividing up retirement plans. The transferring requirements and process for calculating the value of retirement plans are different, whether it is a 401(k), IRA or defined benefit plan.
Keep in mind that some assets are just worth more to one party than the other. For example, Incentive Stock Options (ISOs) convert to non-qualified stock options (NQSOs) and lose their favorable tax treatment when they are transferred from one spouse to another.
Given the rapid growth of ownership of cryptocurrencies and their anonymous nature, it probably makes sense to have special clauses in the divorce settlement agreement that addresses this. The IRS has a heightened focus on cryptocurrencies and is now focusing on transactions over $20,000. It makes senses to have documentation that addresses what would happen if previously undisclosed crypto assets are discovered and how those should be divided up.
3) Produce a pro-forma balance sheet
During settlement negotiations, we recommend modeling out any proposed asset division on a static and pro-forma basis. For example, if one spouse received a home and the other received securities, it’s helpful to see what each party’s assets would look like five or ten years from now taking into account expected rates of return and tax differences.
4) Tread carefully on plans to sell the marital home
For most families, their home is their largest asset, and so typically is the biggest point of contention in divorce settlement negotiations. Selling the home might be a good option for divorcing couples as they divide the marital assets, but selling could be troublesome for a number of reasons. The children are already going an emotionally difficult time with their parents getting divorced, so adding a move out of their home probably escalates the negative emotional impact of the divorce.
As well, selling a home incurs large transaction costs during an already expensive divorce process. Even more, selling during a market downturn could make a potentially financially devastating process even worse. In cases where the value of the home is less than the mortgage, a short sell is an option, which could negatively impact your credit, although the credit impact of a short sale would be far better than a foreclosure.
5) Evaluate the pros and cons of one spouse retaining the home
Some couples negotiate for one spouse to retain the home while retaining the couple’s original mortgage. Before choosing this option, a thorough rent versus buy analysis should be done, so that the financial pros and cons of owning a home are thoroughly vetted. If there’s enough equity in the home and not a lot of non-home assets to divide up in a settlement, a home equity line can be used to allocate marital assets. Retaining the original mortgage can be problematic since both spouses are responsible for the mortgage from the lender’s perspective.
When one spouse quitclaims their interest in the home to the other spouse, they essentially are relinquishing their benefits and rights to ownership while still being liable for the home’s debt.
Refinancing the original mortgage is a preferred solution when one spouse retains the home, but there are some potential issues to consider. Homeowner spouses may not have enough income to pay for the home themselves long-term.
Moreover, qualifying for a mortgage after a divorce could be challenging after the financial effects of a divorce, particularly for the lower income-producing spouse. Lenders will closely scrutinize sources of income, including alimony and child support. The non-homeowner spouse should insist that his or her name be removed from the mortgage to protect their credit.
6) Determine if continuing to jointly own the home may be beneficial
There could be benefits of continuing to jointly own the home for a limited time before a future sale of the house. This option could allow for less disruption in home life for the children. As well, there are potential tax savings from maximizing the use of the $500,000 capital gains exclusion for couples. If one spouse were to take sole ownership of the home and sell, they would only get $250,000 in capital gain exclusion.