Understanding the Tax Treatment of Divorce: Community Property, Separate Property, and IRS Rules

Divorce is not only an emotional process but also a financial one, with significant tax implications. From dividing assets to handling income and future obligations, the classification and division of property have lasting consequences. At Shifflett & Philips CPA, we help clients navigate the tax aspects of divorce, enabling them to move forward with clarity and confidence.

Community Property vs. Separate Property

In the United States, the rules around divorce differ depending on whether you live in a community property state (like Texas, California, or Arizona) or a common law state.

• Community Property States

  • Generally, all income earned and assets acquired during marriage are considered community property, regardless of whose name is on the account or title.

  • In a divorce, each spouse is typically entitled to 50% of the community property, and that division is usually recognized for tax purposes.

  • Example: If a couple in Texas owns a rental property purchased during their marriage, the IRS generally considers it to be jointly owned, and income or deductions are split evenly.

• Separate Property

  • Assets owned before marriage, as well as inheritances or gifts received by one spouse (even during marriage), remain separate property if properly maintained.

  • Income derived from separate property may still be considered community property in some states, unless it is clearly segregated (for example, interest on inherited funds).

  • Commingling funds—such as mixing inheritance money with joint accounts—can unintentionally convert separate property into community property, with both legal and tax implications.

    
    

Division of Property in Divorce

The IRS generally does not treat transfers of property between spouses (or ex-spouses) as taxable if the transfer is “incident to divorce” (IRC §1041).

• No immediate gain or loss is recognized when one spouse transfers their share of a house, stock, or business to the other.

• The receiving spouse takes the carryover basis, meaning they inherit the original cost basis and potential built-in gains.

• This can create a future tax burden: the spouse who later sells the asset may face a larger capital gain than expected.

Example: A house purchased for $200,000 during marriage is awarded to the wife in divorce. Years later, she sells it for $500,000. Even though she “received” the home tax-free at divorce, her gain will be calculated using the original $200,000 basis.

Alimony and Child Support

The tax treatment of spousal support changed with the Tax Cuts and Jobs Act of 2017 (TCJA):

• Divorces finalized after December 31, 2018: Alimony is not deductible by the payer and is not taxable to the recipient.

• Divorces finalized before 2019 (and not modified): Old rules apply, where alimony is deductible for the payer and taxable income for the recipient.

• Child support: Never deductible to the payer and never taxable to the recipient.

Retirement Accounts and Qualified Domestic Relations Orders (QDROs)

Retirement assets often make up a large portion of marital wealth, and special rules apply:

• If a Qualified Domestic Relations Order (QDRO) is used to divide a 401(k) or pension, the transfer is not taxable at the time of divorce.

• The receiving spouse can roll over their share into an IRA, deferring taxes until withdrawal.

• Without a QDRO, early withdrawal penalties and taxes could apply.

Business Ownership and Divorce

If one or both spouses own a business:

• The business may be community property (if started or grown during marriage) or separate property (if owned prior to marriage).

• Agreements about buyouts, valuations, or ongoing distributions need careful tax planning to avoid triggering capital gains or unintended gift tax issues.

Filing Status and Post-Divorce Tax Considerations

After divorce:

• Filing status: You are considered “unmarried” as of December 31 if the divorce is final by year-end. Options are Single or Head of Household (if certain conditions apply).

• Dependents: Only one parent can claim a child as a dependent, which is often negotiated in the divorce decree.

• Estimated taxes: Spouses who previously filed jointly may need to adjust withholding or make estimated payments separately.

Final Thoughts

Divorce involves more than splitting assets—it requires planning for how those assets (and future income) will be taxed. Key areas like community vs. separate property, division of retirement accounts, business interests, and ongoing support all have unique tax consequences.

At Shifflett & Philips CPA, we help clients in Texas and beyond structure their divorce settlements with tax efficiency in mind. Working together with attorneys, we ensure that what looks fair on paper also makes sense for your long-term financial and tax picture.

If you’re facing a divorce—or recently finalized one—reach out to our team to review your tax situation. Proper planning now can save significant money and stress down the road.