Divorcing Before Year-End? Tax Issues High-Net-Worth California Couples Should Consider

December 31 can be more than just another date on the calendar when a California divorce is underway. It can affect how you file your taxes for the entire year, and for high-net-worth couples, the financial consequences may extend well beyond choosing a filing status.

A divorce involving a business, real estate, stock compensation, or substantial retirement assets can create tax questions that deserve attention before a settlement is finalized. The goal is not simply to divide property by its current dollar value. You also need to understand what you are actually receiving, what tax consequences may follow you after the divorce, and whether the settlement assigns responsibility for prior or future tax liabilities.

December 31 Determines Your Marital Status for Tax Filing

For federal tax purposes, your marital status on the last day of the year generally determines your filing status for that tax year.

If your divorce is legally final by December 31, the Internal Revenue Service (IRS) generally considers you unmarried for the entire tax year. You will typically file as single unless you qualify for another status, such as head of household.

Merely signing a settlement agreement or submitting a proposed judgment before year-end does not necessarily mean the divorce is final for tax purposes. The effective date of the judgment terminating marital status must be confirmed.

If your divorce is not final by December 31, you are generally still considered married for federal tax purposes. That may leave married filing jointly or married filing separately as your options, depending on your circumstances.

California generally uses your marital status on the last day of the tax year to determine your state filing status, although California’s rules concerning registered domestic partners and community property may create additional considerations.

That makes the timing of a year-end judgment potentially significant. But tax filing status should not be the sole reason to rush a complex divorce to completion. The difference between December 31 and January 1 may affect one year’s tax return, while a poorly evaluated property settlement can affect your finances for years.

Two Assets Worth $1 Million May Not Leave You With the Same Wealth

This distinction becomes particularly important in high-asset divorces.

Suppose one spouse receives an investment account currently valued at $1 million while the other receives a different asset worth the same amount. On paper, the division may appear equal. After taxes are taken into account, it may not be.

Generally, transferring property between spouses or former spouses incident to divorce does not trigger immediate recognition of gain or loss for federal income tax purposes. The spouse receiving the property generally receives the transferor’s adjusted tax basis rather than a new basis equal to the property’s current market value.

That means an asset can carry a built-in tax consequence.

A stock portfolio purchased for $300,000 and now worth $1 million is financially different from $1 million in cash. If the stock is later sold, its embedded gain can affect what the owner ultimately keeps.

When significant assets are being divided, current market value tells only part of the story. The asset’s basis, liquidity, holding period, embedded gains or losses, and anticipated transaction costs may all affect its after-tax value.

Retirement Assets Require Their Own Tax Strategy

A large 401(k), pension, or other employer-sponsored retirement plan may be one of the most valuable assets in a divorce, but dividing it requires more than assigning a number to each spouse.

Many employer-sponsored retirement benefits are divided using a Qualified Domestic Relations Order (QDRO). A properly structured QDRO can direct a retirement plan to pay an assigned share of benefits to a spouse or former spouse, known as the alternate payee.. Depending on the circumstances, an eligible distribution received by a spouse or former spouse as an alternate payee may also be rolled over tax-free into an individual retirement arrangement (IRA) or another qualified retirement plan.

Simply withdrawing money from a retirement account and then paying it to the other spouse can produce a very different tax result.

IRAs follow separate rules. A transfer of an IRA interest to a spouse or former spouse under a divorce decree or qualifying written instrument generally is not treated as a taxable transfer.

When substantial retirement wealth is involved, the mechanics of the transfer matter.

California Community Property Can Complicate Separate Tax Returns

For couples who remain married at year-end but choose to file separately, California’s community property system adds another consideration.

The California Franchise Tax Board generally requires spouses who file separately to report one-half of community income and all their separate income. For a high-income household with business earnings, investment income, bonuses, stock compensation, rental income, or other substantial sources of revenue, determining what belongs on each return can be complex.

This is one reason a family law attorney and tax professional may need to work together during a high-asset divorce. The family law characterization of income and property can directly affect the tax questions that follow.

Do Not Let the Calendar Make the Decision for You

There can be legitimate reasons to complete a divorce before December 31, just as there can be sound reasons not to force a complex settlement through completion before year-end.

Before agreeing to a high-asset property division, consider questions such as:

• What will your filing status be if the divorce is final this year?
• If you remain married, should you file jointly or separately, and what liabilities could accompany that choice?
• How will any refund, unpaid tax, estimated payment, interest, penalty, or audit adjustment be allocated?
• What is the tax basis of significant investment and real estate assets?
• Are substantial unrealized capital gains embedded in the property you would receive?
• How will retirement accounts be divided and transferred?
• How could California community property rules affect income reporting?
• Does the proposed settlement create tax consequences that are not apparent from the assets’ current values?
• Does the agreement clearly allocate responsibility for previously filed joint returns and any later tax assessments?

Those questions can materially change how a proposed settlement looks.

A high-asset divorce should be evaluated based on the financial position it leaves you in, not simply whether the numbers in two columns appear equal. If you are approaching year-end with significant property still to divide, the Law Offices of David M. Lederman can help you assess the family law issues, coordinate with appropriate financial and tax professionals, and make informed decisions before signing an agreement. Call (925) 690-1466 or contact us online to schedule a consultation about your California divorce