How does the Tax Cuts and Jobs Act (TCJA) affect divorce settlements? Changes in the new law may require divorcing individuals — especially those who own businesses and other investments — to take a different approach to splitting assets and setting maintenance payments than under prior law.
To illustrate, consider Pat and Chris, a hypothetical married couple, who decided to file for divorce on Valentine’s Day 2019. Here’s an overview of several key issues they face.
Business tax issues
Pat is the family’s sole breadwinner. During her 15-year marriage with Chris, Pat started a successful electrical subcontracting business. It’s a C corporation with net profits of $300,000 and $450,000 in 2017 and 2018, respectively. Pat is the company’s only shareholder.
Under the TCJA, tax rates for C corporations have been permanently reduced to a flat 21 percent for tax years beginning in 2018 and beyond. In general, this change would increase a C corporation business’s future earnings and make it more valuable than under prior law.
Important: If Pat’s business operated as a so-called “pass-through” entity — such as a sole proprietorship, LLC, partnership or S corporation — Pat might qualify for a deduction of up to 20 percent of qualified business income. This tax break is only available from 2018 through 2025, unless Congress extends it. It’s not available for C corporation businesses.
There’s more to the TCJA than just lower tax rates, however. There are some additional business-friendly provisions, such as expanded first-year bonus depreciation and Section 179 depreciation deductions for qualified assets and elimination of the corporate alternative minimum tax (AMT).
There are also some provisions that can adversely affect business taxpayers, such as the new limitation on business interest expense deductions and elimination of deductions for business entertainment expenses and domestic production activities.
When valuing Pat’s business, historical results may be less relevant under the TCJA. Projections of future earnings used in valuation will certainly require more than simply multiplying historical results by an expected growth rate. It’s also important to fully understand how the TCJA affects Pat’s company. The changes are sweeping. Some companies will come out ahead under the new law; others won’t.
Investments and real estate
Pat and Chris have other valuable assets in their marital estate, including an investment in a private airplane, a primary residence and a vacation cottage. These assets also are affected by changes included in the TCJA.
Under the TCJA, tax-deferred Section 1031 like-kind exchanges are still allowed for real estate held for business or investment purposes. However, Section 1031 treatment isn’t allowed for exchanges of personal property used for business or investment purposes (such as equipment, airplanes, vehicles and patents) that are completed after 2018. The change, which is permanent, could make these types of assets — including Pat and Chris’s interest in a private airplane — less desirable when settling their divorce.
The TCJA also may have an impact on the perceived value of the couple’s personal real estate, if they live in a high-tax state. Itemized deductions for all state and local taxes (SALT) are limited to only $10,000 for 2018 through 2025. New limitations have also been placed on itemized deductions for home mortgage interest expense for 2018 through 2025, with some exceptions.
Finally, standard deduction amounts have been nearly doubled (to $12,200 for singles and $24,400 for married couples who file joint returns for 2019). So, for 2018 through 2025, fewer taxpayers will itemize deductions and more will claim the standard deduction.
These changes may make principal residences and vacation homes less desirable when splitting up marital assets, because the ex-spouse who receives the homes may not be able to claim as many tax deductions as under prior law.
For more information
As this hypothetical example shows, the TCJA has a major impact on divorce settlements, but every case is unique. Be certain you reach out to a professional accountant who has experience and understanding of these issues and can help divorcing couples customize agreements that work for their situations.