The default position of the IRS is that any transfer of funds from one party to another can be taxed, but there are many exceptions. One is the transfer of funds between spouses. For the most part, any transfer of funds from one spouse to another, whether as a gift or anything else, is outside the purview of taxation.
So, what happens in divorce? Much of the process of divorce is devoted to property division, in which the parties list all their assets and divide their marital property between them in a way that meets the standards of Virginia law. This almost inevitably means transfers of funds between two parties who are no longer married. Should these transfers be taxed?
As long as the parties can show that their transfers of assets were part of the divorce, they should not face tax consequences. However, certain types of assets can trigger significant tax penalties.
Accumulated assets — that is, assets that gained value during the marriage, such as real estate, retirement accounts, stocks and some other valuable assets — can trigger capital gains taxes when they are sold. Divorcing couples often must sell these assets in order to get the cash to settle their property division, but in so doing, they can run into complicated tax issues. Fortunately, there are some ways around the tax penalty that occurs when dividing certain types of accumulated assets.
For instance, it is common for a divorcing couple to sell the family home. If the home has increased in value since its purchase, theoretically the capital gains on the profit should be taxable. However, the IRS allows taxpayers to avoid this penalty in a sale pursuant to divorce under certain conditions. Most importantly, each party must use their profits from the sale to invest in a new home within two years of the divorce. The home must be their principal residence.
There are also ways to help avoid tax penalties for early withdrawal of retirement accounts. People going through a divorce should speak with a skilled attorney about their options for protecting their assets.