FAMILY LAW NEWSLETTER
How Income Taxes Affect Property Settlements
by David Melton
Almost all divorce property settlements are affected by income tax liabilities. This article discusses how courts deal with income tax liabilities and what types of information practitioners should present to the court about these tax liabilities.
Courts can consider tax liability issues in two ways: (1) tax liabilities that directly reduce marital property; and (2) tax liabilities that should be considered as a factor in the equitable division of marital property. The former is a part of evaluating the marital estate to determine the proper amount of marital property to be divided, and the latter is one factor among many that the court considers in the equitable division of marital property.
Direct Reductions of Marital Property
As stated by one commentator, to be a direct reduction of marital property,
Current tax liabilities arising from transactions that have already occurred clearly fall into the category of directly reducing marital property. Additionally, any near-term tax liability from anticipated dispositions of marital property should fall into this category. This would include tax liabilities generated by a court ordered property settlement. Any other type of deferred tax liability would not likely qualify as a direct reduction of marital property.
Tax Factors Affecting Equitable Division
Under the Colorado property division statute, CRS § 14-10-113, the court divides marital property in such proportions as the court deems just after considering all relevant factors. One such relevant factor in many cases is the deferred taxes on marital property:
Because the actual process of equalizing the tax burdens and benefits to each party on an asset-by-asset distribution can be a complicated and cumbersome process, practitioners are well advised to make clear and well-reasoned presentations to the court. Factors to consider include presentation, tax rates, tax basis issues, and present value issues.
To assist the court in considering the tax consequences of all tax-burdened assets, practitioners should present the court with an asset-by-asset accounting. The Appendix to this article provides a sample presentation that includes the following key elements: (1) an asset-by-asset listing of the marital component of each asset; (2) the marital tax basis of each asset; (3) the resulting deferred gain on each asset; (4) how the tax basis of each asset was computed; and (5) a computation of the estimated deferred taxes on all proposed distributions to each spouse.
Once the deferred taxes are computed, practitioners should classify the deferred tax liabilities for the court as either current, near-term deferred or long-term deferred. Current taxes on transactions that have already occurred should be presented to the court as marital liabilities that would reduce the marital estate. Near-term tax liabilities for any anticipated dispositions of marital property, which would include any tax liability generated by a court-ordered property settlement, also would be presented to the court primarily as a marital debt that would directly reduce marital property. Evidence of intent to sell, substantiating any claims for near-term dispositions, should be introduced at trial. Long-term deferred taxes should be presented to the court not as a direct reduction of marital property, but as a factor to be considered in the equitable division of marital property. The court, in its discretion, could then set aside additional marital property for the spouse suffering the greatest long-term deferred tax burden.
The computation of estimated deferred taxes on proposed distributions requires an estimate of each spouse’s tax rate to be used in the calculation. The first step in this process involves a determination of the type of gain each asset will generate. For example, gains on tax-deferred retirement accounts will generate ordinary income when distributed. Gains on appreciation of capital assets will generally result in long-term capital gains ("LTCG").
The second step involves applying an appropriate tax rate for each type of deferred gain. A reasonable approach, for assets that will be sold in the near term, is to use the current income tax rates that each spouse would be subject to, based on historical or projected taxable income. Applying an appropriate tax rate for assets with no clear sale date obviously is more difficult and speculative. One approach is to use the current income tax rates for LTCG and ordinary income as an estimate for future tax rates. If these rates are applied consistently to each spouse, a relatively equal apportionment of the tax burdens and benefits of a particular property division will result. Any actual future change in tax rates most likely will affect both spouses equally.
It is important to remember that the primary goal for computing deferred taxes on a particular property division is to apportion equitably the tax benefits and burdens between the spouses and not to forecast accurately the absolute amount of income tax that will be generated at some distant date.
Tax Basis Issues
When calculating the tax basis on property that contains both separate and marital components, the tax basis of the separate and marital components must be individually calculated. For example, assume an asset worth $750,000 at date of divorce consists of $500,000 of the wife’s separate property and $250,000 in marital appreciation. Further assume that the wife’s separate property tax basis in the asset at the date of marriage was $400,000. A $350,000 total deferred taxable gain would be computed on this property ($750,000 FMV less $400,000 tax basis). This total deferred gain would consist of $100,000 separate property deferred gain and $250,000 in marital property deferred gain. The marital property tax basis is $0 because the marital component of the property is all appreciation during the marriage. Therefore, all of the $400,000 tax basis in the property is the separate property tax basis of the wife and should not be attributed to the marital component of the property.
In calculating deferred taxes on marital property distributions, any statutory tax exemptions should be considered. For example, on the sale of a primary residence, up to $250,000 in taxable gain per spouse can be excluded from income.6 This exclusion amount should be added to the cost basis to produce a total tax basis in the residence. Any gain previously deferred under the old residential reinvestment rules7 or 1031 tax-deferred exchanges8 also should be considered in calculating the tax basis of marital property.
Present Value Issues
The calculation of deferred taxes as discussed above will produce a deferred tax liability that is predicated on selling all assets at the date of divorce at prevailing income tax rates. Because this calculated deferred tax liability is not currently payable, and the precise timing of when each asset will be sold in the future cannot be known at the trial date, it is impossible to calculate the present value of each spouse’s respective deferred tax liability.
This presents a complex problem for the court. How does the court balance the computed deferred tax liability of each spouse’s property division with the probability that certain assets will be sold before other assets? Unfortunately, there is no easy answer. If evidence exists, the court could compute the present value of each respective spouse’s deferred tax liability. If there were no compelling evidence to the contrary, one approach would be to make no adjustment for present value. Under this approach, any present value considerations would, theoretically, already be apportioned on a proportional basis to the deferred tax burden assumed by each spouse in the property division. If the court has a non-quantifiable "feeling" that one spouse’s deferred tax liability is more or less likely to materialize sooner than the other spouse’s, a subjective apportionment of marital property could be made to compensate for that deferred liability.
For courts to deal properly with deferred tax issues in marital property divisions, practitioners and their accounting expert witnesses must provide the court with adequate information and analysis. Clear and well-reasoned presentations are needed that include: (1) all key computational elements; (2) discussion of tax rates used; (3) proper tax basis allocations between separate and marital property; (4) consideration of present value issues; and (5) classification of tax liabilities into current, near-term deferred, or long-term deferred categories in order to assist the court in classifying deferred taxes as: (a) direct reductions of marital property or (b) a factor in the equitable division of marital property.
1. Bateman, "Annotation: Divorce and Separation: Consideration of Tax Consequences in Distribution of Marital Property," 9 A.L.R.5th 568 (1999).
2. In Re Marriage of Bayer, 687 P.2d 537, 539 (Colo.App. 1984); In Re Marriage of Grubb, 721 P.2d 1194, 1196 (Colo.App. 1986).
3. Grubb, supra, note 2 at 1196; In Re Marriage of Finer, 920 P.2d 325, 332 (Colo.App. 1996); Bayer, supra, note 2 at 539.
4. In Re Marriage of Vaccaro, 677 So.2d 918 (Fla.App. 1996).
6. IRC § 121.
7. IRC (Old) § 1034.
8. IRC § 1031.
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Column Eds.: Bonnie M. Schriner, a sole practitioner in Denver—(303) 458-5100; Lesleigh Wiggs Monahan of Polidori, Gerome, Franklin & Jacobson, LLC, Lakewood—(303) 936-3300
This newsletter is prepared by the CBA Family Law Section. This month’s article was written by David Melton, CPA, CVA, a sole practitioner in Aspen, (970) 925-2979.
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