Apparently, New York Mayor
and his wife aren't the only people having marital problems these days.
column on the tax implications of divorce spawned loads of questions. Here are a few estate-planning techniques to consider at the settlement table.
Try a Trust When There Is None
As we mentioned in our earlier piece, alimony payments are deductible to the payer. Child-support payments are not. Some people paying child support may try to disguise it as alimony. But if that "alimony" ends on a child's milestone, i.e., his 18th birthday or the day he goes off to college, the
Internal Revenue Service
will know that you have been camouflaging your child support. You will then be required to pay tax on all that previously deductible money.
Instead of playing games with the IRS to mitigate your tax hit, consider a divorce settlement trust, aka alimony trust.
In simplest terms, you put income-producing property (i.e., stocks, real estate, cash) in a trust and use that income to make your alimony payments, says Seth Starr, a partner at
Frankel Loughran Starr & Vallone
, a financial advisory firm in New York. Because it's your trust, you can decide when the payments will end, with no interference from Uncle Sam.
Let's say you put $1 million in a trust. You mutually decide that the trust will pay your spouse $50,000 in child support annually until your child hits 18. You can then leave whatever is left in the trust to your child. It achieves the same results as paying child support.
Granted, you don't get an alimony deduction for the money paid out to your spouse, but it's almost like you do, notes Starr. The money now is out of your estate so you won't owe tax on the appreciation, unless the appreciation is higher than your spousal payments. If you decide to pay your spouse $60,000 a year and the trust earns $80,000, your spouse will owe tax on $60,000 and you will owe taxes on the $20,000 difference.
"It's an alimony trust with an estate-planning twist," says Carlyn McCaffrey, a partner in New York law firm
Weil, Gotshal & Manges
and co-author of
Structuring the Tax Consequences of Marriage and Divorce
. In essence, you've shifted the tax burden to your ex. So it's as if your spouse received an alimony payment, instead of child support through a trust. Remember, the receiving spouse pays tax on alimony, but child support payments are tax-free.
There are perks for the receiving spouse. A trust offers payment security. The money is going to keep coming for the allotted time because a trustee, a person other than your spouse, will control the trust. So you don't have to worry about your ex-spouse skipping town with your child-support money.
Note: You may owe a bit of gift tax on the present value of all your alimony payments when you set up the trust. But check out
Section 682 of the tax code for more grist on these trusts.
This trust could work with a business you started as well, suggests McCaffrey. Let's say you created a dot-com company, worth around $2 million, and you're convinced it's going to be the next
. (Hey, you've got to think big.) But you're getting divorced and your spouse wants half.
Put 50% of the company's stock in a trust, suggests McCaffrey. Set it up so that your spouse gets $100,000 a year for the rest of his or her life. Any remainder can go to your children. Again, you may owe gift tax upfront on the present value of those payments.
Home Sweet Home -- Not
What do you do with the house? You understand that your spouse needs to live there while the kids are still at home, but you don't want to turn over the title.
If you jointly owned a house and believe that you can sell it for at least $250,000 more than you originally paid, consider keeping the home in both your names. At a minimum, you deserve a piece of the gain.
Remember the home-sale exclusion rules? As long as the home was your principal residence and you lived there for two of the last five years, as a married couple you won't owe capital-gains tax on a maximum of $500,000 of profits from the sale. Single people get a $250,000 exclusion.
But thanks to a quirk in the tax code, there's a perk for divorced people. As long as the home's title is still in both of your names, you'll each get a $250,000 exclusion at the time of sale -- even if you haven't lived there in years. So if the home sells at a $300,000 profit, you'll each get $150,000, capital gains-tax-free. Just make sure you have that written into your divorce decree, reminds Starr.
If, instead, you had fully transferred the home's title to your spouse, you'd lose that "free" money. Granted, it's unusual to own something jointly after a divorce, but for tax purposes you may want to consider it.
Here's another scenario to ponder. It was decided in the divorce settlement that your spouse will live with the kids in your family home. But not only do you not want your spouse to end up with the house, your intent is to leave it with your kids.
So consider a qualified personal residence trust, suggests McCaffrey. A qualified personal residence trust, or QPRT, is an irrevocable trust that allows you to give your home away at a discounted price. Basically, you transfer the home to the trust for a determined number of years but retain ownership of it. The value of the house is discounted over those years, so when the trust expires, the value of the house is worth much less on paper (even though its market value may be much higher). And that discounted amount is what you may owe gift tax on. So when you turn the house over to your kid, your gift-tax bill will be minimal. See a previous
Tax Forum for more on these trusts.
Be sure to write something in the trust's documents that says your spouse can live there until, say, your child goes off to college.
Change Your Beneficiary Designations
A quick reminder: Assuming your IRA, 401(k), life-insurance policy or any other asset that requires a beneficiary is left intact after your divorce, make sure you change the beneficiary designations to remove your spouse if you no longer want your money to be distributed that way. Many people forget to do this, says Starr. Granted, it's an administrative pain, but it's worth it.
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TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.