Biggest Hidden Costs of Divorce

One of the greatest detriments to your personal financial health is divorce. It is not only the cost of the attorneys and professionals that may be needed during the divorce process, but also additional fees for title transfers on some platforms, fees to divide qualified retirement accounts, appraisal costs for house, collectibles, etc., and title transfer on real estate if not done properly.

There are tax consequences of various decisions in the division of assets, unrealized gains that may be properly accounted for, and the long-term consequences of certain financial arrangements.

The lack of knowledge in understanding the financial implications of dividing assets may lead to unexpected expenses and financial hardship in the future for either or both spouses.

Retirement Asset Withdrawal

One little known consequence may be penalized throughout retirement. With divorce for senior couples on the rise, it is critical to understand the implications of withdrawing retirement funds within two years of receiving Medicare.

There is a special consideration of a penalty-free withdrawal (waiver of 10% penalty) of retirement assets incident to divorce because the needs of couples divorcing may require earlier access to those funds. But a note of caution is in order if those assets are withdrawn.

Those retirement funds are considered and taxed as ordinary income. This impacts all who withdraw assets at any age. 

But many do not recognize that withdrawals will also impact Medicare premium payments two years in the future as the lookback for setting the premium rates for Medicare in any given year is a two-year period. Medicare looks back to your 1040 for income purposes. There is no relief for funds being withdrawn from retirement coffers rather than income actually earned.

Marital Home

One multi-faceted cost involves the marital home. In many situations, mortgages are not assumable by only one party and there is a need to refinance the home. That is a major issue that affects qualifying for the refinanced mortgaged rate (which in recent years has escalated three-fold), but also in affording the expense with post-divorce cash flow.

Another concern with the marital home is the loss of one of the spouse’s $250,000 capital gain exclusion that could be realized on the eventual sale of the home. If one spouse is awarded the home (and an equity buyout is made to the other for his/her share in the home’s equity), the spouse with the home will have forfeited $250,000 in relief from tax on any capital gain in the home. Each spouse is allowed $250,000 maximum capital gain exclusion every 2 years. If the spouses are not selling within a 6 year time period (considered incident to divorce by the IRS), if both spouses’ names are not left on title, and if not explicitly written into the Marital Settlement Agreement that the non-residing spouse retains the rights to the exclusion, this exclusion may be forfeited for one of the spouses.

The spouse who is awarded the marital home is not always receiving an asset at face value. There are maintenance costs, capital expenses (e.g. roof, windows, HVAC), insurance, property taxes for the home while owned. Upon sale there may be staging costs, repair costs, inspection costs, and additional closing(1-2%) and commission costs (5-6%) that eat into the value of the home that was identified in the “equitable” division of assets. And these may not necessarily be offset over the years by the appreciation of the home.

Divorcing couples would be well advised to consider the costs associated with the marital home both now and in the future.

Investment Assets

The division of assets often overlooks the underlying unrealized gains or losses that may be inherent in certain investment asset positions. If the asset division is strictly made according to the valuation of the assets according to market value as of a certain date, there may be hidden surprises in the taxation of the unrealized gains embedded in those assets. This could result in receiving far less assets that originally recognized in the division process.

Also, certain assets are taxed differently than others. Careful evaluation of the short-term tax impact vs. long-term tax impact of each investment asset should be done. Also, some tax impacts are typically overlooked such as the recaptured depreciation that may be due on the sale of investment rental property or even on the sale of the marital home if a home business took depreciation annually on the home and now the home is being put up for sale or awarded to the other spouse. At some point that depreciation recapture must be repaid to the IRS and the amount of the recapture is typically significant, at 25%.

Moving Costs

Another significant hidden cost of divorce in the near term is the cost of moving. In addition to the cost of the moving company, spouses may incur the cost of disposition of unwanted—even donated—large items. Oftentimes, donation centers will not send a truck to pick up items and the removal and transport of items from the marital home may involve costs of services such as Task Rabbit to simply take items to a donation center or a dump which also charges a fee to deposit items.

There may be costs associated with temporary or permanent storage of items as the home is staged for sale or if one of the spouses (or both) are in a temporary housing situation such as a rental for a few years before buying a new home.  

Business Valuation

Many divorcing couples make the mistake of not wanting to spend money on a closely held business appraisal. While the cost can be expensive, $10,000-25,000 or more, it is well worth while to understand the valuation of the business that is to be divided or awarded to one or the other spouse. There are many implications to how the deal is structured when buying the other spouse out of their share share of the business and this creates additional hidden costs to either the spouse personally, or to the business.

While the business owner, who generally will be keeping the business, will need to offset the other spouse’s interest in the business (usually at 50%)with other marital assets or a promissory note for future payments. This results in either a significant loss of other assets to the spouse retaining the ownership of the business, another reason for a true business valuation to be conducted so that the business is not overly valued.

Even worse is the undervaluation of a business if the business is not properly appraised. Not everything that appears on the stated books of the business constitutes the true value of the business. Many hidden gems are included in a business and these may not only affect the division of assets that are offset for the valuation of the business, but also may affect the amount of spousal support and child support that should be paid. For example, many closely held businesses commingle the personal/family expenses with those of the business (e.g. autos, insurance, etc.).

Other Personal Costs

Divorce can take a toll on a person’s emotional and physical health. The stress and anxiety associated with a divorce can lead to increased healthcare costs, there is sometimes postponement of important medical attention as one progresses through the divorce, and the recognition of increased healthcare costs (when a spouse is removed from the company-provided health insurance of the other spouse).

Moreover, there may be additional therapy, counseling, and medication required throughout the divorce process not only for the spouses but also for the children. This may have a significant impact on finances as most therapists do not take insurance.

Finally, the time-consuming and demanding nature of divorce with court appointments, legal deadlines, etc., may impact a person’s ability to work and earn income, resulting in lost wages or a reduction in productivity that could impact future raises or promotions.

It is important to not only understand what assets and liabilities there are in the marital financial snapshot, but also what underlying tax implications are embedded in them. During the divorce division of assets, it is imperative to identify and understand the financial implications of each decision, from added costs and fees, to unrealized costs and future costs, to impacts of the division decisions on retirement and other financial considerations.

While divorce is expensive simply for the professional fees and associated costs, it is not the time to be cost-cutting in key areas that could result in financial inequalities that significantly affect the financial security of one or the other spouse post-divorce. This is especially salient in the case of the valuation of closely held businesses. The risk is too high that one or the other spouse will be detrimentally affected by not doing proper due diligence on this asset during the divorce proceedings.

This article does NOT constitute legal advice and is for general information purposes ONLY. Prior to making any decisions, seek legal counsel from a licensed attorney.