When evaluating the fairness of a potential property settlement in a divorce case, lawyers should pay close attention to the tax effects the settlement will have on their clients. The lawyer who fails to account for tax issues may see a potential division of assets as fair when in reality the division of assets may be quite lopsided after the assets are taxed.
Consider an example of a husband and wife who divorce with only two community property assets: the husband’s 401k with a $100,000 account balance, and their home with $100,000 equity. A simple way to settle this case would be for the husband to retain his 401k and for the wife to receive the equity in the marital residence. This would be equal, right? Wrong! The division is equal only if the parties disregard that the husband’s 401k is an entirely tax-deferred asset and that the house equity is likely not taxable at all if and when the wife decides to sell it.
To compare “apples to apples”, the husband’s lawyer should present evidence and argument showing that the 401k is worth only $60,000 – $70,000 after taxes and potential early-withdrawal penalties. To equalize the division of the assets, wife should pay husband $15,000 – $20,000. Alternatively, the home could be sold with the net proceeds equally divided, and the 401k could be equally divided via qualified domestic relations order.
Another easy-to-miss issue is unrealized capital gains. Assume the husband and wife have two investment assets, both with a net value of $150,000. One is a West-Valley rental home purchased in a foreclosure sale three years ago for $75,000. The parties have depreciated the home a couple of years, and it currently has a tax basis of $70,000. With the recent increase in home values, however, the rental home has now appreciated to a value of $150,000. The other investment asset is stock in a tech company purchased for $150,000 in 2007 when the market was at what was then an all-time high. Although the stock price dropped significantly when the market crashed, the parties hung on to the stock, and the stock is finally now again worth what the parties paid for it.
The parties agree that wife will receive the rental home and husband will receive the stock. Is the division fair? No. If wife sold the rental home today, she would pay capital gains tax on $80,000 of the sale proceeds ($150,000 sales price less tax basis of $70,000). If the stock were sold for $150,000, however, there would be no capital gains tax because there would be no gain on the sale– the stock is being sold for the same price the parties paid for it. After capital gains taxes, the spouse with the house gets the short end of the stick in this example.
When cases don’t settle, the parties and their attorneys should present evidence at trial addressing the taxation of the various assets at issue. When I first started practicing law, Arizona case law specifically directed judges to disregard taxation issues as being too speculative. A few years ago, however, the legislature amended A.R.S. Section 25-318 to allow family court judges to consider the tax issues attendant to the court’s division of marital property. A.R.S. Section 25-318.B. now states in pertinent part as follows: “In dividing property, the court may consider . . . accrued or accruing taxes that would become due on the receipt, sale or other disposition of the property.”
Does all this mean that a divorce lawyer has to be a tax expert? Hardly. A good divorce lawyer simply needs to be sufficiently tuned-in to the tax issues so he recognizes when he needs help. Many clients have relationships with their own CPAs or other tax advisors. These or other tax experts should review proposed property settlements when the lawyers are uncertain as to the potential tax effect of the settlement terms on their clients. Obviously, this needs to happen as part of the negotiation process and before the parties sign a binding property settlement agreement.
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