Divorce, death pose tax twists

I always enjoy reconnecting with clients during tax season. Many times joyful events have occurred during the year, such as marriage or the addition of a child to the family. These positive events often have a favorable impact on their tax return.

Unfortunately, difficult situations also arise that bring challenges to the preparation of the tax return. Many of my clients are aging and are facing health problems. Sadly, some clients had to cope with the death of a spouse in 2007. A sound record-keeping system and the help of a family member or close friend can be extremely important in situations such as these.

On top of the emotional strain, the tax implications of divorce can be very unsettling, especially because of community property laws. In Texas and other community property states, communal assets are distributed equally, regardless of who earned more or spent more during the marriage. The courts typically allow the couple a certain amount of flexibility in deciding how to divide things.

Even if assets are split equally in dollar amount, certain assets may have less favorable tax treatment than others.

The two largest assets most couples hold are typically a house and retirement plan assets. In most cases a home can be sold with no tax impact, whereas the liquidation of retirement plan assets is a taxable transaction. If the retirement plan assets are sold before the account holder reaches age 59 1/2, the IRS assesses an additional penalty of 10 percent.

Stocks and bonds held in taxable accounts could generate capital gains or capital losses.

One approach to an equitable distribution of assets in a divorce would be to segregate assets by categories -- for example, cash and money market accounts, retirement assets, taxable stocks and bonds, personal property and real estate. Then assets in each category could be split evenly. This approach may not be appropriate if one spouse wants to keep the house; if the home represents a large portion of the total assets, this will skew the distribution. In this case, it may be best to hire a financial professional to assess the tax impact of various allocation approaches.

Divorce courts typically allocate the couple's debts evenly, but many creditors ignore this allocation and hold both parties liable. In some cases, there may be protection under the IRS Innocent Spouse provisions.

I typically suggest that clients pay off all joint liabilities before dividing asset accounts and close all joint accounts. In most cases mortgage debt can be assigned to the spouse who will keep the house.

Taking these extra planning steps during the divorce process will eliminate having to address financial problems after the divorce, when an amicable settlement is less likely to be reached.

More at the El Paso Times.