In divorce proceedings, property owned by the spouses must be classified and divided between them. Among the factors determining who currently has title to specific assets and how they will be divided is the couple's state of residence, the location of the property, and where, when, and how the assets where acquired. State law varies in defining marital property. Generally, marital property includes all property that either spouse has acquired during the marriage, except for property acquired by inheritance or gift. Separate property is property that each spouse has acquired before the marriage, through inheritance or gift during the marriage, and after separation. Most states assume that assets acquired during the marriage are marital. It may be necessary for a spouse to trace the origins of funds used to acquire property in order to prove that the property is separate.
Property divisions are based upon the concept of equitable distribution. This concept states that each spouse has a legal right during marriage to the other spouse's earnings and to the assets acquired by those earnings. Accordingly, courts must perform three tasks:
(1) clarify all assets either as marital or separate
(2) value the assets and
(3) distribute the assets equitably.
Courts will consider the duration and quality of the marriage, marital fault, monetary and nonmonetary contributions to the marriage, each spouse's earning ability, separate property of each spouse, their ages and health, custody of children, and other factors. Because of the impossibility of physically dividing certain assets, such as the marital residence or a business, spouses will have to be assigned other assets in exchange or the property will have to be sold to facilitate an equitable distribution. Sometimes it is necessary to trace separate property if, for instance, it has been used to acquire other property, it has been commingled with marital property, or if its value has increased significantly.
For income tax purposes, a transfer of property from one spouse to the other "incident to the divorce" is tax-free. This means that no gain is recognized by the transferor spouse. This includes sales or exchanges of property between ex-spouses within one year of the end of the marriage and transfers pursuant to a divorce or separation agreement generally occurring within six years after the end of the marriage. Such transfers are treated the same as gifts for income tax purposes. The transferor's tax basis and holding period carry over to the taxable gain or loss on the difference between the tax basis obtained from the transferor and the selling price. Because of this, a spouse who is offered a particular asset in a divorce settlement should determine the estimated taxable gain upon its potential sale in order to arrive at an after-tax value for the asset. All significant assets to be divided should be valued in this manner in order to produce an equitable distribution of assets on an after-tax basis.
