Tax Traps in a High-Asset Michigan Divorce

In a high-asset divorce, the number on the balance sheet is not the number you get to spend. A $1 million brokerage account, a $1 million 401(k) and $1 million of home equity look equal on paper. After taxes they can be worth very different amounts. A settlement that divides the marital estate "50/50" on paper can leave one spouse with substantially less in real money.

This post covers the federal tax issues that come up most often in Oakland County high-asset divorces. It is general information, not tax advice. Every client with significant assets should have a CPA or tax advisor review the proposed settlement, and we coordinate with them as part of the case.

The Basic Rule: Transfers Are Tax-Free, But Basis Carries Over

Under 26 USC 1041, transfers of property between spouses, or between former spouses when the transfer is incident to the divorce, generally do not create taxable gain or loss. That is good news: you can move the house, the brokerage account or the business interest from one spouse to the other without an immediate tax bill.

The catch is basis. The receiving spouse takes over the original owner's tax basis. If stock was bought for $100,000 and is worth $1 million today, the spouse who receives it also receives roughly $900,000 of built-in capital gain that will be taxed when it is sold.

Example. One spouse takes $1 million in cash. The other takes $1 million of stock with a $100,000 basis. If the stock is sold, federal long-term capital gains tax (often 15% to 20%, plus the 3.8% net investment income tax for high earners) and Michigan's 4.25% income tax could cost more than $200,000. The two halves were never equal.

Retirement Accounts: Pre-Tax Dollars and the Right Paperwork

Most 401(k) and traditional IRA money has never been taxed. A dollar in a pre-tax retirement account is worth less than a dollar in a savings account, because income tax will be due when it comes out. Trading retirement assets for cash or home equity should be done after adjusting for that future tax.

How the account is divided matters too:

• Employer plans (401(k), 403(b), pensions) are divided with a Qualified Domestic Relations Order (QDRO). A distribution paid to the former spouse under a QDRO is exempt from the 10% early withdrawal penalty under 26 USC 72(t)(2)(C), although ordinary income tax still applies. That can make a QDRO a useful source of cash for a spouse under 59½ who needs liquidity.
• IRAs are not divided by QDRO. They are split by a transfer incident to divorce under 26 USC 408(d)(6), and the receiving spouse's new IRA is treated as their own. Withdrawals before 59½ from that IRA are generally subject to the 10% penalty, so a spouse who needs cash should usually take it from the employer plan under the QDRO, not the IRA.
• Roth accounts have already been taxed and are worth more, dollar for dollar, than pre-tax accounts.

A poorly drafted QDRO can lose survivor benefits or create avoidable tax. See Gray Divorce in Michigan for more on dividing pensions.

The House: Timing Can Be Worth $250,000 of Exclusion

Under 26 USC 121, married couples filing jointly can generally exclude up to $500,000 of gain from the sale of a principal residence they have owned and lived in for two of the last five years. A single filer can exclude up to $250,000.

In Bloomfield Hills, Birmingham and other Oakland County communities, long-held homes often carry gains well above $250,000. If the house will be sold anyway, selling while still married and filing jointly may let the couple use the full $500,000 exclusion. If one spouse keeps the house and sells years later as a single filer, only $250,000 may be available, and the rest of the gain is taxable.

There is also a helpful rule for the spouse who moves out: when a divorce or separation instrument gives the other spouse use of the home, the spouse who moved out can generally be treated as still using it as a residence for purposes of the exclusion. That needs to be planned for in the judgment.

Spousal Support Is No Longer Deductible

For divorce or separation agreements executed after December 31, 2018, federal law no longer allows the paying spouse to deduct spousal support, and the recipient no longer reports it as income. Before 2019, support was deductible to the payer and taxable to the recipient, which often made higher payments possible because the government effectively shared the cost.

Two practical consequences:

1. The same monthly number costs the payer more than it used to, which affects what is realistic to negotiate.
2. Older judgments keep the old rules unless they are modified and the modification expressly adopts the new treatment. Before modifying a pre-2019 support order, consider whether doing so will change the tax treatment.

For how Michigan courts set spousal support, see Spousal Support in Michigan.

Stock Options, RSUs and Deferred Compensation

Equity compensation creates both valuation and tax issues. Unvested awards earned during the marriage are often divided using a coverture fraction. Taxes then depend on the type of award:

• RSUs are generally taxed as ordinary income when they vest.
• Nonqualified stock options are generally taxed as ordinary income when exercised. When options are transferred to a former spouse incident to divorce, the IRS has ruled (Revenue Ruling 2002-22) that the spouse who receives and exercises them reports the income.
• Incentive stock options have their own rules and often cannot be transferred without losing favorable treatment, so they are frequently divided by a deferred distribution arrangement instead.

See Stock Options, RSUs, and Deferred Compensation in a Michigan Divorce.

Business Interests

When one spouse keeps a closely held business, the valuation drives the buyout. Whether the valuation accounts for taxes, how the buyout is paid (a lump sum, a note, or a property equalization) and whether the business will need to distribute cash to fund it all affect the after-tax result for both spouses. See Dividing a Business in a Michigan Divorce.

Children and Filing Status

• Who claims the children. Federal rules generally give child-related tax benefits to the parent with more overnights unless that parent signs a release (IRS Form 8332). The judgment can require a release, and it should be negotiated along with support.
• Filing status. Your filing status for the year is determined by whether you are married on December 31. A judgment entered in late December changes which return you file for the whole year.
• Head of household. A parent who pays more than half the cost of keeping up a home for a qualifying child may file as head of household, which has better rates than single status.

Tax Debts and Refunds

Joint returns create joint liability. A settlement should allocate responsibility for any taxes owed on past joint returns, any audit exposure, and how refunds, estimated payments and carryforwards (such as capital loss carryovers) are divided. If you are concerned about what your spouse reported on joint returns, ask about it before signing.

The Bottom Line

The fair way to compare settlement proposals in a high-asset case is after tax. That means listing each asset with its value, its tax basis, whether it is pre-tax or after-tax, and when it is likely to be sold or withdrawn. Our high-asset divorce practice works alongside clients' CPAs and financial advisors to do exactly that.

If you are dividing significant assets in a Michigan divorce, a free, confidential consultation can help you see what a proposed settlement is really worth.