Are Divorce Settlements Taxable? What the IRS Actually Says
Divorce is already emotionally devastating — and then comes the tax bill. The truth is that most property transfers in divorce are not taxable, but the details matter enormously. Alimony rules changed dramatically in 2019, retirement account transfers require specific legal orders, and your filing status in the year of divorce can save or cost you thousands. Here's what you need to know.
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Talk to AI Advisor NowProperty Division Is Generally NOT Taxable (IRC Section 1041)
The single most important tax rule in divorce is Internal Revenue Code Section 1041. This provision states that transfers of property between spouses — or between former spouses if “incident to divorce” — are treated as gifts for tax purposes. No gain or loss is recognized at the time of transfer.
What IRC 1041 covers:
- ✓Real estate — Transferring the family home, rental properties, or land to one spouse as part of the settlement triggers no immediate tax.
- ✓Investment accounts — Stocks, bonds, mutual funds, and brokerage accounts can be transferred between spouses tax-free.
- ✓Business interests — Ownership stakes in businesses, partnerships, or LLCs can be transferred without triggering a taxable event.
- ✓Bank accounts and cash — Dividing cash or savings accounts is not a taxable event.
The transfer must occur either during the marriage or within one year of the divorce, or be “related to the cessation of the marriage” under a divorce or separation instrument. Transfers made within six years of divorce are presumed to be incident to divorce if made under the decree or agreement.
Important caveat: While the transfer itself is tax-free, the receiving spouse inherits the original cost basis of the asset. This means when they eventually sell, they may owe significant capital gains tax. More on this below.
Alimony: The Rules Changed Dramatically in 2019
The Tax Cuts and Jobs Act (TCJA) of 2017 fundamentally changed how alimony (spousal support) is taxed. The critical date is when your divorce or separation agreement was executed:
Agreements executed BEFORE January 1, 2019
Under the old rules (IRC Sections 71 and 215, now repealed for new agreements), alimony is taxable income to the recipient and tax-deductible for the payer. The recipient reports it as income on their tax return; the payer deducts it as an above-the-line deduction. These old rules continue to apply unless the agreement is specifically modified after 2018 to adopt the new TCJA rules.
Agreements executed ON or AFTER January 1, 2019
Under the TCJA, alimony is not taxable to the recipient and not deductible by the payer. The money is treated essentially like child support for tax purposes. This means higher-income payers lose the deduction benefit, and recipients don't have to report it as income. Depending on each spouse's tax bracket, this can significantly affect the total after-tax value of spousal support.
Strategic consideration: Because the payer no longer gets a deduction for post-2018 agreements, the total “cost” of alimony is higher. This has led to lower alimony amounts in many negotiated settlements, or creative structures where property division is used instead of ongoing payments.
Child Support Is NEVER Taxable
This rule is straightforward and has not changed: child support is not taxable income to the recipient and not deductible by the payer. It makes no difference when the agreement was signed or how much is paid.
Be careful about agreements that blur the line between alimony and child support. The IRS has specific rules (sometimes called “front-loading rules”) to prevent disguising alimony as child support or vice versa. If payments decrease when a child reaches a certain age or milestone, the IRS may reclassify part of the payment as child support, regardless of what the agreement calls it.
The Hidden Tax Trap: Capital Gains and Cost Basis Carryover
While property transfers between spouses are tax-free under IRC 1041, there's a critical catch: the cost basis carries over. This means the receiving spouse inherits whatever the original purchase price was — not the current market value.
Example: The $200,000 tax bomb
Your spouse purchased stock for $50,000 that is now worth $250,000. In the divorce, you receive the stock. Your cost basis is $50,000 (not $250,000). When you sell, you owe capital gains tax on $200,000 in gains — potentially $30,000 to $74,000 in federal taxes alone (at 15–37% depending on your income bracket and how long the asset was held).
Why this matters in settlement negotiations
Not all assets are created equal. Receiving $250,000 in stock with a $50,000 cost basis is worth significantly less than receiving $250,000 in cash or a home with a $250,000 basis. A smart settlement accounts for the after-tax value of each asset, not just the current market value.
Real estate and the primary residence exclusion
Under IRC Section 121, you can exclude up to $250,000 of capital gains ($500,000 if married filing jointly) on the sale of your primary residence if you lived there for at least 2 of the last 5 years. If you keep the family home in the divorce but sell it years later, make sure you still qualify for this exclusion. The clock is ticking once you move out.
Retirement Accounts: QDROs and Tax-Free Transfers
Retirement accounts are often the largest marital asset after the family home. Dividing them correctly is essential to avoid early withdrawal penalties and unnecessary taxes.
401(k), 403(b), and pensions: Use a QDRO
A Qualified Domestic Relations Order (QDRO) is a court order that directs the plan administrator to transfer a portion of one spouse's retirement account to the other spouse. When done through a QDRO, the transfer is tax-free and penalty-free. The receiving spouse gets their own account and controls when to take distributions. Without a QDRO, a withdrawal would be taxed as income and potentially hit with a 10% early withdrawal penalty.
IRAs: Transfer incident to divorce
Individual Retirement Accounts (IRAs) do not use QDROs. Instead, a divorce decree or separation agreement directs the IRA custodian to transfer funds to the other spouse's IRA. This is a tax-free and penalty-free transfer under IRC Section 408(d)(6). The receiving spouse treats the transferred IRA as their own.
Future withdrawals ARE taxed
While the transfer itself is tax-free, any subsequent withdrawals from the retirement account are taxed as ordinary income (for traditional accounts). Early withdrawals before age 59½ generally incur a 10% penalty, though there is a special exception: QDRO distributions taken immediately from a 401(k) (before rolling over to an IRA) are exempt from the 10% early withdrawal penalty.
Real Estate Transfer Tax Exemptions During Divorce
When real estate changes hands, most states and municipalities impose transfer taxes (sometimes called deed transfer taxes or recording fees). However, many jurisdictions provide exemptions for transfers between spouses as part of a divorce:
- ✓Federal level — IRC 1041 ensures no federal income tax on the transfer. There is no federal transfer tax on real estate.
- ✓State level — Most states exempt transfers between divorcing spouses from state transfer taxes. However, the rules vary. Some states require the transfer to be pursuant to a court order; others require it to occur within a specific time frame after divorce.
- ✓Local level — County and municipal transfer taxes may or may not have divorce exemptions. Check your local rules — this is an area where a real estate attorney or tax professional familiar with your jurisdiction is essential.
- ✓Mortgage considerations — Transferring the deed does not transfer the mortgage. If both spouses are on the mortgage, the remaining spouse typically needs to refinance. This can trigger new closing costs and potentially a higher interest rate.
Filing Status in the Year of Divorce
Your tax filing status is determined by your marital status on December 31 of the tax year. This single date controls your options for the entire year:
Still married on December 31
You can file Married Filing Jointly (MFJ) or Married Filing Separately (MFS). MFJ usually results in lower total taxes, but both spouses are jointly liable for the entire return. If you don't trust your spouse's financial disclosures, MFS may be safer even though the tax rate is higher.
Divorced by December 31
You must file as Single or Head of Household. You cannot file jointly with your ex-spouse, even if you were married for 364 days of the year. Some couples strategically time their divorce finalization to optimize their filing status.
Head of Household (most advantageous for single parents)
If you are unmarried on December 31, paid more than half the cost of maintaining your home for the year, and have a qualifying dependent (typically a child) who lived with you for more than half the year, you can file as Head of Household. This gives you a larger standard deduction and more favorable tax brackets than Single filing status.
The 'Abandoned Spouse' rule
Even if you are technically still married on December 31, you may qualify for Head of Household status under the 'considered unmarried' rule (IRC Section 7703(b)) if: your spouse did not live in your home for the last 6 months of the year, you paid more than half the cost of maintaining the home, and you have a qualifying dependent.
8 Common Tax Mistakes During Divorce
These errors can cost you thousands — or lead to IRS problems years after your divorce is finalized:
- 1.Ignoring cost basis when dividing assets — Treating all assets as equal based on current market value without accounting for embedded capital gains taxes.
- 2.Failing to get a QDRO — Withdrawing from a retirement account to give your spouse their share instead of using a QDRO. This triggers income tax and potentially a 10% penalty on the full amount.
- 3.Applying wrong alimony tax rules — Using pre-2019 rules for a post-2018 agreement or vice versa. The date of the agreement, not the date of divorce, controls which rules apply.
- 4.Missing the primary residence exclusion deadline — If you move out of the family home but keep ownership, you must sell within 3 years to use the IRC 121 capital gains exclusion (2-out-of-5-year rule).
- 5.Filing jointly when you shouldn't — Signing a joint return makes you liable for your spouse's tax obligations. If you suspect unreported income or fraud, file separately.
- 6.Forgetting to update withholding and exemptions — Your tax situation changes dramatically after divorce. Update your W-4 with your employer immediately to avoid a large tax bill or refund imbalance.
- 7.Not addressing the child tax credit and dependency exemptions — Only one parent can claim a child as a dependent. The custodial parent has the default right, but IRS Form 8332 can transfer it. This should be addressed in the divorce agreement.
- 8.Transferring property to a non-spouse after the deadline — IRC 1041 only applies to transfers incident to divorce. If you transfer property to your ex-spouse years later without meeting the criteria, it may be treated as a taxable sale.
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Legal Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Tax laws are complex and change frequently. The information provided here reflects federal tax rules and may not address state-specific tax implications. Individual tax consequences depend on your specific circumstances, including income level, asset types, state of residence, and the terms of your divorce agreement.
Always consult with a licensed tax professional (CPA or enrolled agent) and a family law attorney before making tax-related decisions during divorce. The references to IRC Sections 1041, 71, 215, 121, 408(d)(6), and 7703(b), as well as the Tax Cuts and Jobs Act of 2017, are provided for educational reference and should not be relied upon as current legal authority without professional verification.