The Illiquid Marital Estate: Navigating the Division of Marital Residences and Retirement Accounts

By Elizabeth Hutchison, CPA, CDFA, AKT LLP CPAs and Business Consultants, Lake Oswego, Ore.

Editor: Michael D. Koppel, CPA/CITP/PFS, MSA, MBA

While many people enter into marriage with the intent of upholding the vow "till death do us part," the reality is that divorce often occurs for a variety of reasons.

While most couples do not have significant liquid assets, it is common for a majority of couples to own a home and have one or multiple retirement plans. Usually, these two assets make up the bulk of the assets that the couple must divide. Even though there may be equity in the family home, additional savings, and other liquid assets, the cost of a divorce often erodes these assets.

The topics and ideas discussed in this item provide a starting point as a practitioner begins to consider each client's unique financial situation. It focuses on common pitfalls and potential opportunities to consider in the illiquid marital estate arena.

Pitfall: Becoming House Poor

Decisions regarding the family home tend to be one of the most sensitive topics in a divorce. Emotional attachment to a home can be particularly difficult to deal with. Often one spouse wants to keep the home indefinitely; however, if the divorcing couple do not handle the home properly, it may be lost. For example, if the home is too expensive, it may fall into foreclosure, or the recipient of the home might exhaust his or her assets to keep it, causing long-term financial problems for the parties.

The following options are the most common to consider when a home is part of the marital estate:

1. Sell the home;

2. Continue joint ownership; or

3. Refinance the home.

To determine which option is best in their situation, a divorcing couple should consider each spouse's financial needs.

First Option: Sell the Home

If the couple have to sell, they should be mindful of the timing. Despite the parties' wants and desires to remain in the home, the reality is that home equity may be the only asset, or there is no way to fairly balance the marital division if one spouse keeps it. Besides the potential financial benefits of finding a more affordable living situation, selling the home may be the most valuable option. A couple should strongly consider this strategy if it is possible to sell the home and remain in the lowest income tax bracket.

For example, in a year that the couple are still considered married or post-divorce (assuming they are considered to mutually own the home), they could each qualify for a Sec. 121 exclusion. Married couples who meet the two-out-of-five-years test, in addition to the use tests, can qualify for an exclusion of $500,000 to offset the potential gain on a home. This means each would receive a $250,000 exclusion.

Now that a higher long-term capital gain tax bracket is in place, management of tax brackets becomes an essential tool, assuming there is appreciation beyond the exclusion. When a practitioner analyzes whether clients would receive a greater benefit by filing jointly or separately, this can be a useful point to consider. This potential tax benefit can help to maximize the after-tax value of the marital estate and provide cash to help the individuals begin their next chapter.

Second Option: Continued Joint Ownership

One option to consider is for both ex-spouses to continue owning the home and sell later. If it is financially viable for one of the spouses to use the marital home for a certain period of time after the divorce is finalized, then there is the potential for the exclusion to be maintained by each spouse even for an extended period of time after the divorce is finalized. Sec. 121(d)(3)(B) allows the nonresident spouse to treat the period that the resident spouse uses the property as a primary residence to count for the two-out-of-five-years test for the Sec. 121 exclusion, thus preserving the Sec. 121 exclusion for a later date for both spouses.

Third Option: Refinance the Residence

Refinancing a home can provide a number of benefits, including reducing the cost of keeping the house, removing the name of the other spouse from the loan, and potentially freeing up cash to assist in equalizing the settlement. Although there are immediate financial benefits, it is important bear in mind that currently refinancing will likely cause the tax deduction for the mortgage expense to decrease. Because the refinanced debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing, if one spouse leverages equity to buy out the other spouse's portion, there might be further limits on the deductibility of interest. Lastly, the upfront costs of refinancing a loan can take a period of time to recoup.

Pitfall: Unintended Taxable Distributions From Retirement Plans

A divorcing spouse may make significant errors when transferring a retirement plan. The most common pitfall is failing to complete a direct rollover of funds from a qualified retirement plan to an individual retirement account. Individuals are generally familiar with the 60-day rule under Sec. 402(c)(3), but when funds are withdrawn from a qualified plan, an automatic withholding of 20% applies. Besides the recipient only getting 80% of the amount, if the amount of the withholding is not deposited into an IRA, income tax as well as the 10% addition to tax for premature distributions could apply to the withholding. As long as the transfer is completed properly under the appropriate court order, the withholding would be available to offset taxes of the recipient spouse for the tax year in which the distribution occurs.

The other significant failure is not completing the transfer due to mistakes with the written court order. For qualified plans, a court order transferring the benefits must meet the requirements to be a qualified domestic relations order (QDRO). One of these requirements is that the plan administrator must review the court order and determine whether the order is a QDRO. If the order is not drafted properly and approved, one spouse may not be able claim his or her agreed-upon portion of the qualified account. For additional details as to the general requirements of a QDRO, see Sec. 414(p).

For IRAs, the transaction needs to be considered incident to a divorce. Some custodians may request a court order before transferring some or all of a retirement account. If a transaction is not considered incident to a divorce, the distribution from one spouse to the other will be deemed taxable and potentially subject to the 10% addition to tax to the transferor spouse.


A QDRO can be structured to help the nonparticipant spouse. Under a QDRO, distributions from a qualified plan to the nonparticipant spouse under the age of 59½ will not be subject to the 10% tax under Sec. 72(t)(2)(A)(v), although the distribution would still be taxable as ordinary income. However, the ability to access this cash can be extremely useful in the individuals' transition to post-divorce life. This provision is specific to the nonparticipant spouse and a qualified plan. Distributions from a QDRO can be rolled over tax-free into an IRA, but if they are rolled over to an IRA, the Sec. 72(t)(2)(A)(v) exclusion does not apply when the funds are distributed from the IRA.

The other common exclusion from the 10% tax occurs with the distribution of substantially equal periodic payments based on the life expectancy of the individual (or life expectancies of the individual and his or her beneficiary) or until reaching age 59½ (Sec. 72(t)(2)(A)(iv)). This is generally used with IRAs and is potentially available for qualified plans upon termination to eliminate the 10% tax. The payments do not need to occur over a lifetime but must continue until the later of the individual's turning 59½ or the close of the five-year period starting on the date of the initial distribution (Sec. 72(t)(4)(A)(ii)). Keep in mind that, generally, other than a modification due to death or disability, any modification may lead to a 10% tax. There is flexibility when setting up substantially equal periodic payments in the sense that one can limit the balance that the payments are based on by including either one or multiple IRA balances. A taxpayer can also roll over funds to a new IRA creating the specific balance needed.

Final Considerations

Since the majority of divorcing couples have a home or a retirement account, knowledge of common pitfalls and opportunities is helpful. When cash is limited, making the right choice is critical. Each opportunity has its risks, but far greater costs can result if all options are not properly considered. Divorce is a painful process, and the ease created by financial peace post-separation will be priceless to clients.


Michael Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

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