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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 definitely 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 of 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 things in terms 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 trying to convince 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 prior to a trial. 

Either way, whether your cases 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. The decisions that you make in the divorce are going to be impacted by your emotional state just as much as by the actual facts and circumstances that you are encountering. 

I would like to share with you 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 difficult to keep up not only with the property that is in play but also in regard to the circumstances that need to be considered as well. 

First off, I would take out a piece of paper and make some columns in order 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 that is 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 done regarding the more valuable pieces of property. Regardless, you need an estimate of these values for your own reference. It is helpful in mediation to have an extra copy for your spouse so that he or she can 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 different 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. Best outcome, next best outcome, 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 considering 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 is going to be in play when dividing up property in your divorce. As you can see, 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 true value of counts as property in your divorce.

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

You need to be aware, however, that all property that you and your spouse own at the time of divorce is presumed to be community property. As such, be aware 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 with me that you owned a house prior to when you and your husband got married 14 years ago. During the course of your marriage you kept the house in your name alone 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 on the home. As a result, the value of the house 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 have 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 would need to consider that the mortgage payments have increased the equity in the home for you. As the mortgage was paid down the equity that you had 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 on the home? If he 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, as well. All other increases in the value of the home would likely be considered separate property since they would have occurred regardless of whether or not your husband had married you fourteen years ago. 

The end 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 separate property and part community property. Many spouses bypass this discussion and determine that the house is all your separate property, but that your husband would have a right of reimbursement for the contributions that he made to the increase in equity/decrease in the mortgage balance during the course of 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. Prior to January 1, 2018, payments of contractual alimony or spousal maintenance in Texas could be deducted by the spouse who makes the payments after a divorce has been finalized. Likewise, the payments 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. What that means for you is 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 in the divorce you agree to pay or receive a lump sum of property rather than a smaller monthly payment structure then you will have to pay taxes on that payment. 

Of course, check with a financial planner, accountant or other tax professional on this before you make any decisions moving forward. Taxes, like the law, can be a complicated subject and 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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