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Is a lump sum payment in a divorce settlement taxable?

Ah, taxes. As if a divorce isn't bad enough on its own you also have to think about the tax implications of the decisions that are made within your case. It's a situation where you are adding insult to injury. Regardless of how it makes you feel, the reality is that you signed up for the divorce and have to take on the responsibilities that come along with it.

Even if the divorce wasn't your idea, it is a train ride that you best take inside the train cars rather than outside. A favorite author of mine is fond of telling people: the only people who get hurt on a roller coaster are those who jump off. Meaning: if you are in for a bumpy experience (like divorce), you are better off staying the course and seeing the process through to the end.

Divorce makes it easy to think of who owns what and who has given what property away to their spouse during negotiations. I should mention here that most divorces end up settling in mediation rather than go all the way to a trial. The media does a great job of convincing us that every divorce case is a knock-down, drag-out fight. In reality, 90% (if not more) of Texas divorces settle at various points before a trial.

Either way, whether your case goes all the way to a trial or is settled in an earlier stage of your case, your divorce is going to be an emotional time for you and your family. Your decisions in the divorce will be impacted by your emotional state, just as by the facts and circumstances you are encountering.

I want to share some helpful hints on how to begin to think about how property may be divided up in your divorce. From there, we can discuss tax issues related to this division, including whether or not a lump sum payment in your divorce is taxable or not.

Dividing property in a divorce- one way to lay it all out

Your divorce is likely more complex than you give it credit for. Even "simple" divorces can end up being more complex than the participants would have imagined at the beginning of the case. As a result, it can be challenging to keep up with the property in play and the circumstances that need to be considered.

First off, I would take out a piece of paper and make some columns to differentiate between the four issues that we need to be aware of during settlement negotiations related to property. In the first column, you need to list out any property in play- regardless of whether it is your separate property, your spouse's separate property, or part of your community estate. After each piece of property, you should note which estate you believe the property falls into.

Next, you can write the value of each piece of property as far as you believe. These are rough estimates, and that is fine. If you are nearing the end of a divorce, it may pay to work with your spouse to get formal appraisals or estimates regarding the more valuable pieces of property. Regardless, it would help if you had an estimate of these values for your reference. It is helpful in mediation to have an extra copy for your spouse to see from what basis you are operating as far as coming up with settlement proposals.

Next up, speak to your attorney about what each piece of property could sell for on the open market. This is a different figure than what we just finished talking about. What an item is worth can be completely other than what it can sell for. Remember, a buyer isn't so much concerned about an item's worth as he is with its value. What would a willing buyer offer to purchase the property for on the open market?

Finally, you need to come up with your proposed division of the community estate. Remember that a court cannot divide up any property that is a part of either your separate estate or that of your spouse. All community property is fair game for division. Do not go into settlement negotiations without having first considered how a division may occur. You can even create multiple sets of outcomes for yourself and yourself. The best result, following best development, worst-case scenario, etc. You may not have as much time to create these outcomes in mediation as you would have anticipated, so you and your attorney need to do this work ahead of time.

What does property mean in the context of a divorce?

Property is one of those words where we all have an idea of what it means but may not know exactly what it means in this context. Does it mean things that are inside your house? What about vehicles? Does money count as property, like in a bank account? Do you treat retirement savings the same way that you would regular savings in a bank account? Most of all, what about the family house? Could you and your spouse be forced to sell it?

These are all perfectly logical questions to have at this point in your divorce. You would have very little reason to know the answer to any of those questions ahead of time since you haven't planned your life around getting divorced- at least, I hope you haven't. Let's take a look and see what a family court in Texas would be considered when dividing up community property in your divorce.

Your houses, any rental property that you own, vehicles, bank accounts, investments, pensions, retirement savings, and the list goes on and on as far as what will be in play when dividing up property in your divorce. As you can see, the property takes on many different forms in a divorce. It is not merely property that you can reach out and touch right now. Even a pension account that you don't even know the actual value of counts as property in your divorce.

As far as separate property is concerned, any property you owned before your marriage, the property you inherited before your marriage, or property you received as a gift during your wedding counts as separate property. These are the items that you could count as not being divisible by the judge.

However, you need to be aware that all property that you and your spouse own at the time of divorce is presumed to be community property. As such, be mindful that if you and your spouse disagree on how you characterize property that it is up to you to prove with evidence that a particular piece of property is part of your separate estate.

A real-world example of the breakdown between community and separate property

Assume that you owned a house before when you and your husband got married 14 years ago. You kept the place in your name alone during your marriage and never titled it into your and your spouse's names together. Mortgage payments were made on the house out of your jointly held bank account. Your husband also contributed his work and sweat towards making improvements to the home. As a result, the house's value increased a fair amount during the fourteen years of your marriage.

So, is that house your separate property, or did it become part of the community estate due to your husband's work and the mortgage payments contributed by your dual incomes? As with most things related to divorce, it gets a little complicated.

We can say with confidence that your separate property share of the home is the value of the house on the date that you and your husband got married, minus whatever you owed on the mortgage at that time. It's unlikely that you had an accurate appraisal of the home back in 2006, but you can come up with a decent estimate to submit into evidence if need be. Your husband could, of course, do the same, and a judge would need to select what he thinks to be the more accurate assessment of value.

Next, you need to consider that the mortgage payments have increased the equity in the home for you. As the mortgage was paid down, the equity in the property also increased, assuming that the value at least held steady and didn't decrease faster than the mortgage was being paid off. Keep in mind that since those mortgage payments were jointly held income, the increase in equity would have to be community property.

What about your husband's work at home? If they remodeled a few rooms, updated the plumbing and electrical work, and landscaped the backyard, those efforts would likely place any increased equity in the column of community property. All other increases in the home's value would probably be considered separate property since they would have occurred regardless of whether or not your husband had married you fourteen years ago.

The result of this discussion is that the house which had formerly been your separate property 100% on the day of your marriage slowly became part individual property and part community property. Many spouses bypass this discussion and determine that the house is all your particular property. Your husband would have a right of reimbursement for the contributions he made to the increase in equity/decrease in the mortgage balance during your 14-year marriage.

Lump-sum payments made in a divorce: taxable or not?

Lump-sum payments of property made in a divorce are typically taxable. Let's give this discussion some context. Before January 1, 2018, fees of contractual alimony or spousal maintenance in Texas could be deducted by the spouse who makes the costs after a divorce has been finalized. Likewise, the charges were taxable income for the spouse who receives the payments.

A recent change to the tax code did away with that, however. Now those payments are no longer deductible. That means that if you are the spouse who is made to pay spousal maintenance or agrees to make contractual alimony payments, you will be on the hook for paying the tax just as if it were ordinary income. Divorce just got a whole lot more expensive, possibly.

Lump-sum property payments have always been taxable, however. They never got the favorable tax treatment that alimony/spousal maintenance payments once did. If you agree to pay or receive a lump sum of property in the divorce rather than a smaller monthly payment structure, you will have to pay taxes on that payment.

Of course, check with a financial planner, accountant, or another tax professional on this before you make any decisions moving forward. Taxes, like the law, can be a complicated subject. It is best to receive personalized advice about your circumstances rather than rely on generalized information intended for a broad audience.

Questions about property division, taxes, and divorce? Contact the Law Office of Bryan Fagan

If you have any questions about the information contained in today's blog post, please do not hesitate to contact the Law Office of Bryan Fagan. Our licensed family law attorneys offer free-of-charge consultations six days a week here in our office. These consultations are great because they allow you to ask questions and receive direct feedback about your specific circumstances.

We appreciate the opportunity to share some information about divorce with you today. Our office values the relationships we are fortunate to share with our clients a great deal. Thank you for spending some time with us today on our blog.

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