Happily ever after is all too often a fairy tale. Statistics show that for many, the nightmare of a divorce will be the reality. If you find yourself going through the ordeal of divorce, please take time to put emotions aside long enough to become comfortable with and fully understand the financial consequences of your settlement.
Divorcing partners often rush into the division of assets. Sometimes both of them have been fully involved in handling the family finances and investment decisions, but often one spouse has controlled or made the majority of decisions concerning the finances during the marriage. In either case, it is very important for each party to find their own trusted advisor familiar with the financial and tax aspects of divorce. This is key in helping each party take the emotion out of the settlement and ensuring that each spouse has a fair and healthy financial outcome.
Liquidity of Assets
Liquidity refers to the ability to convert an asset to cash. Think of it this way – while the house may be at the top of your “want” list, you can’t pay medical bills, student loans, or taxes with a house. You need cash. You’ll want to make sure in the property division that you receive liquid (or can be easily liquidated) assets in an amount that when combined with your income from other sources allows you to meet your current and foreseeable cash flow needs. Receiving marketable securities or cash may be a better choice than the house if you don’t have earned income or sufficient income-producing assets.
All assets are not created equal! It’s imperative that both parties understand the character and nature of the assets they take away under the settlement agreement. Before making any decisions on the division of assets, it’s strongly recommended that you first prepare a budget to determine your monthly financial needs. The budget will help determine which assets best fit your goals. Below we’ve identified some important, but easily over-looked, considerations when embarking on a property settlement.
Growth/Earning Potential of Assets
Many times spouses sit down with a list of assets and their current Fair Market Values (“FMV”) and divide the assets solely based on each receiving the same dollar amount. This asset allocation is not always equitable as each asset may have different growth and earning potential. Cash and publicly traded securities of $500,000 may go to one spouse and the ownership of a business worth the same today may go to the other spouse. But how much income does the business distribute to owners each year and what will that business ownership be worth in a year, in ten years, in twenty? Don’t blindly give up assets that throw off a great stream of income or that could double or triple in value down the road! It’s also important to pay attention to the allocation of non-income-producing assets. When non-income-producing assets are over allocated to a spouse who does not have an independent stream of income, he/ she may be forced to burn through assets following the divorce merely to maintain his/her lifestyle, whereas the spouse with an independent stream of income is able to cash flow his/her lifestyle and replenish his/her assets.
Tax Consequences of Assets
As in the example above, let’s say you fought hard for that business interest knowing its growth and earning potential would pay off. Did you consider and understand the tax impact to you of the business’s earnings? Did you also consider the tax consequences of a sale? Regarding a sale, it’s important to think through the “net” proceeds to you after payment of any capital gains taxes or other taxes owed. You’ll owe a capital gains tax on the sales proceeds less your basis when it’s sold. It’s possible you would have been better off taking an asset that has no tax impact. Tax basis should always be considered when allocating assets. Another example would be if you receive part of a pension or retirement account – while the guaranteed income is a plus, don’t forget to consider the impact of taxes on the distributions you receive.
Some very important assets that are often not considered in property settlements can be found on the tax return – carryovers. These could be passive loss carryovers, charitable carryovers and capital loss carryovers. If a couple has joint investments where losses are being accumulated until a future time when they can be used, these are certainly worth consideration. Let’s say the couple chooses to split the investment 50/50, yet one spouse is unaware of the loss carryovers, he/she could find themselves in a completely different tax situation in the year in which those losses could be used and the other spouse gets full benefit of such. The same holds true for charitable and capital loss carryovers. It’s crucial that both parties have complete copies of prior year tax returns and work with a tax professional to fully understand what carryovers exist and the impact they have on the property settlement.
Maintenance Costs of Assets
This category reminds us of the importance of preparing a budget before finalizing a settlement agreement – it’s critical to understand cash flow needs on the front end. One spouse may have their heart set on that rental property in Florida, but in the haste of negotiating they fail to consider the costs of maintaining the property. These costs can be both financial and physical. Some of the financial costs will typically include property taxes, repairs & maintenance expenses, and possibly a monthly mortgage expense. Though things may have gone smoothly over the last several years, what happens if the property fails to rent for several months? Can you manage the expenses? Does your job, or day-to-day demands allow you to travel multiple times a year to check on the property and handle the repairs? The same holds true for the marital residence. This is often times the most “emotional” asset, leaving it as one of the hardest to give up. Costs to maintain the home though can be overwhelming for a spouse without an independent stream of income. Give ample thought to the costs associated with the assets you choose for yourself. While it may be difficult to consider, with these types of assets, the best long term solution may be to sell the property and share the proceeds (again after considering any potential tax consequences).
As we’ve pointed out above, there are many considerations before agreeing on a property settlement. One of the healthiest things you can do for your marriage is to be educated about your finances from the start. Make it a habit to update Net Worth statements every few years, identifying both joint and separate assets, as well as liabilities. Doing so will keep you and your spouse on the same page, and will also have you best prepared if problems arise in your marriage. Our team would be happy to help navigate you through any questions you may have.