Yes, there is a specialty of Divorce Tax Planning. But why, you ask?
For example, if a property settlement involves capital assets, an unsuspecting spouse might obtain an asset that has been depreciated. If this is the case, the recipient spouse has a built in taxable gain. Worse yet are the depreciation recapture provisions. What appears to be a 50/50 split is not so.
Similar is the case with deferred tax income property. There are many, many tax traps in divorce settlements. Likewise, there are many opportunities to take optimize the tax code during the course of a divorce.
Most people only obtain appraisals. A property’s fair market value is only part of the picture. The property’s tax attributes are the other part. This is where I come in.
Many years ago, I tried to repair a taxable event where a spouse received over a million U.S. in her bank account for a fleeting moment. Receipt of money is a tax recognition event. It was in the context of a corporate dissolution and divorce. What appeared to be harmless turned out to be a very large and unexpected tax bill. This is more common than you might imagine. I will also add that both spouses were represented by large prestigious law firms. Tax law takes no prisoners.
If you are involved in a divorce and have assets worth worrying about, I can review the proposed distribution to ensure an equitable tax result.
*In addition, if you intend on filing for Innocent Spouse Relief after the divorce is final, I can review the proposed court order, stipulation, or settlement agreement to ensure that certain key tax provisions are contained in it.
Divorce attorneys are very good at what they do, I have witnessed. They have a lot to keep their eye on. It is very prudent for wealthy individuals with high net worth estates to obtain competent tax counsel. It can save thousands and headaches. For example, post divorce taxpayers will finally separate their finances. Consistency among their tax returns is important. inconsistencies can and probably will raise IRS issues and possibly an audit.
Alimony
In general, alimony is deduction by the payor, and inclusion by recipient. If you are the payor, it is a deduction on the first page of the 1040, line 31a, which is a very favorable position.
There may be optimizations to classify property settlements as alimony, depending on the drafting of the stipulation, court order, and also timing of payments.
IRC §71(f) seeks to prevent such classifications.
Prenuptial Due Diligence
If you are getting married to an individual who is a bit older or who runs a small business I dare say that it is prudent to run a tax compliance check-up. You can ferret out hidden tax problems before marrying the individual.
Divorce is not just a legal event — it is a tax event. The decisions made during a divorce proceeding affect federal and Colorado income tax liability, capital gains exposure, retirement account division, and estate planning for years after the decree is entered. Philip Falco, Attorney, CPA, works with divorcing individuals and their family law attorneys to identify tax consequences before they become binding obligations, and to structure settlements that minimize the overall tax cost of separation.
Transfers of Property Between Spouses: IRC § 1041
The fundamental rule governing property transfers in divorce is IRC § 1041, which provides that no gain or loss is recognized on a transfer of property between spouses — or to a former spouse if the transfer is incident to divorce. “Incident to divorce” means the transfer occurs within one year of the marriage ending, or is related to the cessation of the marriage under a written instrument.
The critical point most clients miss: the transferee spouse takes the transferor’s adjusted basis in the property. A transfer of appreciated stock, a rental property, or a business interest may be tax-free at the moment of transfer, but the receiving spouse inherits a potentially large embedded capital gain. We analyze the after-tax value of each asset class in a proposed settlement — not just the face value — so you are comparing apples to apples.
Example: Spouse A receives the $500,000 marital home (basis $150,000). Spouse B receives $500,000 in retirement account assets (pre-tax). On paper the split looks equal. In practice, Spouse A has a $350,000 embedded gain subject to capital gains tax on future sale, and Spouse B’s account balance is entirely pre-tax and will be reduced by ordinary income tax on withdrawal. The net values are not equal.
Alimony and Spousal Support: The TCJA Change
Under the Tax Cuts and Jobs Act of 2017, for divorce or separation agreements executed after December 31, 2018, alimony is no longer deductible by the payor or includable in income by the recipient. This is a fundamental shift from the prior law that governed decades of divorce settlements.
- Agreements executed before January 1, 2019 remain under the old rules (deductible/includable) unless the parties modify the agreement and elect the new treatment.
- Agreements executed after December 31, 2018 provide no tax deduction to the payor and no taxable income to the recipient.
The practical impact: the tax benefit of alimony as a settlement tool is gone for new cases. We advise clients and their family law counsel on how this affects settlement structure, including whether to characterize payments differently or to shift value through other means.
Retirement Account Division: QDROs and Their Tax Consequences
Division of qualified retirement plans (401(k), 403(b), pension plans) in divorce requires a Qualified Domestic Relations Order (QDRO) — a separate court order that instructs the plan administrator to assign a portion of the benefit to the alternate payee (the non-employee spouse). Without a proper QDRO, a direct transfer from a retirement plan to a non-participant spouse is a taxable distribution subject to income tax and potentially the 10% early withdrawal penalty.
Key tax points:
- A QDRO transfer to an alternate payee is not a taxable event at the time of transfer.
- The alternate payee can roll the funds into his or her own IRA, deferring taxation until withdrawal.
- Alternatively, the alternate payee can take a distribution directly from the plan (without rolling over), which is subject to income tax but exempt from the 10% early withdrawal penalty — even if under age 59½. This exception does not apply to IRA transfers.
- IRA assets do not require a QDRO. A divorce decree or separation agreement is sufficient to authorize a tax-free transfer between IRAs.
Errors in QDRO drafting are common and expensive. We review proposed QDRO language to confirm tax compliance before it is submitted to the plan administrator.
Capital Gains Exposure: The Marital Home
The primary residence exclusion under IRC § 121 allows a taxpayer to exclude up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale of a home, provided the ownership and use tests are satisfied (owned and used as primary residence for at least two of the five years preceding sale).
Divorce creates several traps here:
Timing of sale. If the home is sold while the couple is still married and both spouses meet the use test, the full $500,000 exclusion is available. If the sale occurs after divorce, each spouse can claim only $250,000 — and only if they individually satisfy the ownership and use tests.
Use test after separation. A spouse who moves out of the marital home may lose the two-year use requirement if the divorce takes long enough. We track this and advise on timing.
Buyout. If one spouse buys out the other and keeps the home, the remaining spouse’s basis is stepped up to the buyout price. The remaining spouse may want to consider selling before a significant appreciation period begins.
Joint Tax Liability and Innocent Spouse Relief
Spouses who file joint returns are jointly and severally liable for all tax, interest, and penalties on that return — even if one spouse earned all the income or caused the underpayment. A divorce decree assigning tax liability to one spouse does not bind the IRS; it only creates a right to contribution between spouses.
If your spouse (or former spouse) understated income or claimed improper deductions without your knowledge, you may qualify for Innocent Spouse Relief under IRC § 6015(b), Separation of Liability under § 6015(c), or Equitable Relief under § 6015(f). We have handled these cases at the administrative and Tax Court levels.
We also strongly recommend that divorce decrees and settlement agreements contain specific language addressing responsibility for tax liabilities, IRS audit exposure for joint return years, and indemnification obligations.
Colorado State Tax Considerations
Colorado generally conforms to federal treatment for property transfers under § 1041 and follows federal adjusted gross income as the starting point for Colorado taxable income. However, Colorado has its own treatment of certain retirement income and its own additions and subtractions. We ensure Colorado filings are consistent with the federal structure of the settlement.
Frequently Asked Questions
Should I hire a separate tax attorney in addition to my family law attorney?
Family law attorneys are skilled at legal strategy and courtroom advocacy, but tax analysis of proposed settlements is a specialized task. Many family law attorneys engage us specifically to advise on the tax consequences of settlement terms before the decree is finalized. It is far less expensive to model tax consequences before signing than to discover a significant tax problem after the fact.
Is child support taxable?
No. Child support is neither deductible by the payor nor includable in the income of the recipient. It has no income tax consequence.
What if my ex-spouse fails to pay taxes that the divorce decree says are his or her responsibility?
If the liability stems from a joint return, the IRS can still collect from you. Your remedy is against your former spouse under the indemnification terms of the decree — which may or may not be collectible. This is exactly why the language in the decree matters, and why addressing open tax years before finalizing settlement is advisable.
We have an S-corporation. How is that divided in divorce?
S-corporation interests are particularly complex. Transfer of stock is generally tax-free under § 1041, but valuation, built-in gains exposure (if the corporation converted from C-corp status), and income allocation during the year of transfer all require careful analysis. We work with business valuation experts and model the post-division tax profile for both parties.
Contact Us
Tax consequences in divorce are often irreversible once the decree is entered. We encourage early engagement — ideally before settlement terms are drafted. Call (303) 626-7000 or email Phil@ColoradoLegal.com to schedule a consultation. Philip Falco, Attorney, CPA, handles divorce tax planning personally.
Philip Falco, Attorney, CPA · 730 17th Street, Suite 900 · Denver, CO 80202