divorce tax issuesA CPA recently wrote to TaxMama struggling with a problem. Her client got divorced and paid her ex-husband for half the value of the house he bought before they were married. Now this lady is selling the house. Doesn’t seem like much of a problem, does it?

Well, this was a house that the ex-husband had bought about 20 years ago. He had rolled over the profits from the sales of two previous homes, so the tax value (tax basis) of the house was much lower than his purchase price, reduced by the profits that were not taxed the first two times he had sold a home.

What’s the big deal? The ex-wife could just ask him for the figures, right? Remember, this involves a divorce—and divorces are not always friendly. As it happens, in this case, it was friendly—but the ex-husband had passed away, making him hard to interrogate.

This problem could have been avoided entirely in one of two ways.

  1. The ex-husband could have kept the home. Since the ex-wife was giving him over $100,000 anyway, she could have easily used that money as the down payment on a similar home in that neighborhood.
  2. He could have stayed on title until their child grew up, even if he wasn’t living in the house. This strategy would have worked whether he lived or died:
  • If he were still alive and the couple sold it, they could have used two personal residence exclusions of $250,000 each instead just of one.
  • Because he died, the whole house would have gotten a step-up in basis to the fair market value at date of death. (Note that it might have only been his half of the house that received this benefit, depending on how they held title.)

As you can see, when going through a divorce, it’s very important for the two parties to do more than split the current value of assets evenly. It’s crucial to understand the underlying tax consequences of those assets as well.

Understanding assets and how they are taxed

What assets are apt to cost the recipient hidden taxes (or cause tax headaches) while appearing to generate an equal split?

  • All real estate with equity—especially rental real estate. The depreciation will be recaptured at a 25 percent tax rate when the property is sold.
  • Stocks—especially those held for a long time, with splits, reinvestments, and so on. Not only will you have gains, you may also have a problem trying to determine the underlying cost for tax purposes.
  • Collections—such as coins and stamps. Does anyone have records covering the original cost of those items?
  • Annuities. All of the value over the original cost is taxable.
  • IRAs or retirement accounts. These funds are generally fully taxable.
  • Savings bonds. Most likely, none of the interest was ever taxed.

Have your tax pro review all the assets being split during the divorce. Don’t let the pro just take a quick glance and shrug it off. Insist that he or she ask the right questions about the basis. Get all the documentation to prove the tax cost for your files. Know what you’re really getting—not just what you think you’re getting.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.