Most any divorce is going to have some type of tax ramifications. It might be determining who claims certain deductions or who is eligible for child tax credits. However, in high-net-worth and high-income situations, the planning issues are a little different. The dollar amounts can also be significantly larger, which makes it even more important to get the right structures in place.
Determine How You Will File in the Year of the Divorce
The very first thing to figure out is how you will file your tax return in the year you get divorced. Your tax status on the last day of the year determines how you file. For example, if the divorce is final by December 31st then your filing options for that year include filing Single or Head of Household. However, when you get divorced partway through the year, how do you know how to allocate the various income items and deductions for the year? For example, if you get divorced in June and one party is awarded some rental property, do they report the rental income for the entire year or just for the half of the year after which they were awarded the property?
In the same way, you have deduction items that would simply be available to both parties on a joint return. However, now filing two returns, you must determine how those will be allocated. Every situation is unique, however, the important thing is that it’s discussed in advance so there are no surprises after the divorce is over and people go to file their separate tax returns. In very complex situations, I have suggested to clients that even though the entire property division is completed, they should wait to make the divorce final until January 1st so they can file a joint return for the previous year. This can potentially save a lot of time and money versus having to argue over who will report different items of income and expense.
Determine if You Will Lose Certain Tax Treatments
Many times, high-income couples have certain tax-favored treatments. For example, if one person works in real estate, whether as a builder, developer or salesperson, that may afford them a special tax treatment called Real Estate Professional. As a Real Estate Professional, they can deduct expenses that non real estate professionals can not deduct. After the divorce, if the non-real estate spouse is awarded rental properties, they may not be eligible for these special tax deductions. This also involves planning to determine if they would want to accept these properties as part of the property settlement or if they should have a different type of asset.
In addition, this same thing can be true for people who run a business and are considered to actively participate in the business. If the spouse who was not part of the business is awarded some or all of the business, their situation would be treated differently. The important thing here is to understand that these treatments exist and to plan for them as part of a settlement.
Don't Forget About Any Tax Carryforward Items
Also, in high net worth situations, you can easily have various carry forward items. Maybe the couple has a rental property and over the years they have not been able to deduct all of the rental losses. This would afford them a rental loss carry forward or generally called a passive loss carry forward. After the divorce, who is awarded this carry forward? How will they determine if one party is able to use it or if it must be divided? In addition, there may be many other carry forwards such as capital loss carry forward, charitable contribution carry forwards, etc. These have value to the person who can deduct them in the future. These tax carry forwards, in some situations, can be significant and potentially could end up with one spouse who is unable to use them for many years or even potentially unable to use them before they expire. Again, the critical thing is to recognize that these items exists and then to work the property settlement to the advantage of one or both parties so that these items can be used.
In a high net worth and high-income divorce, having certain professionals on your side is critical. Beginning with the family law attorney who is experienced and skilled at situations involving complex finances. The other critical person is a financial advisor who has experience with these tax issues. These are not situations that an average investment person would see very often. Having someone who has this type of experience can greatly enhance the settlement process, and it can provide you the best financial organization as you move forward with your new life.