If you are getting a divorce, taxes are probably not highest on your list of concerns. Still, you should consider a number of tax-related issues.
File Jointly or Separately?
For tax purposes, the law determines a person’s marital status on the last day of the tax year. Thus individuals who separate, but don’t divorce, during the year typically will need to make a choice. They will have to choose between filing jointly or separately.
Filing separately may result in the loss of valuable tax credits and deductions. For example, the American Opportunity Tax Credit is not available to a married taxpayer who files a separate return. Typically, filing jointly will result in the lowest overall tax.
One reason to consider filing separately is for protection from the other spouse’s future tax liabilities. Generally, spouses who sign joint returns have joint and several liability — meaning that they are each fully liable for unpaid tax liabilities arising out of the return. Moreover, the IRS has the right to pursue the party who is best able to pay the full amount quickly. Thus the two filers have to work out the issues of fairness between them. The “innocent spouse” rules and/or the “separate liability” election may provide protection in some circumstances.
Property Settlements in a Divorce
Dividing property in connection with a divorce generally has no immediate consequences for either spouse. However, if the spouse who receives property in the divorce settlement later sells it, there may be a gain to report for tax purposes. So, potential taxes should be a consideration in deciding which spouse will receive which property.
Note that a spouse who receives property in a divorce figures any gain on a subsequent sale of the property using the transferring spouse’s basis (e.g., cost), not the property’s value when it was received.
Example. Michelle receives 10 acres of unimproved land in her divorce settlement. Her ex-husband bought the land for $25,000. It’s now worth $100,000. If Michelle sells the land for $100,000, she will have to report a taxable gain of $75,000. This is the difference between the $100,000 selling price and the $25,000 cost basis.
If a divorcing couple sells their home while they are still married, they are entitled to exclude up to $500,000 of gain from their taxable income if otherwise eligible for the exclusion. If one spouse simply transfers the ownership of the home to the other spouse as part of the divorce settlement, there is no taxable gain or loss at the time of transfer. However, should that spouse later sell the house while he or she is unmarried, only a $250,000 exclusion would be available.
A divorce settlement often determines how the spouses will divide the retirement plan benefits between them. However, an employer may distribute retirement plan benefits to a former spouse only after receiving a court-issued document that meets the requirements for a qualified domestic relations order (QDRO). The benefits are taxable to the former spouse who receives them pursuant to a QDRO.
The spouse who has legal custody of a child generally claims the dependency exemption. But this tax advantage is negotiable and can change from year to year. The custodial spouse can waive his or her right to the exemption, allowing the noncustodial spouse to claim it.
Claiming a child as a dependent may impact other tax benefits. For example, if a child is attending college, the spouse who claims the student as a dependent can claim either the American Opportunity Tax Credit or the Lifetime Learning tax credit for tuition paid, assuming they meet the eligibility requirements. The law also allows a child tax credit of up to $1,000 annually for each qualifying dependent child under age 17.
Alimony vs. Child Support
Payments that qualify as alimony under the tax law are deductible by the paying spouse. They are taxable income to the recipient spouse. Child support payments, on the other hand, are not deductible by the paying spouse. And they are not included in the recipient spouse’s income. The IRS characterizes payments that are linked to an event or date relating to a child — such as high school graduation or a 21st birthday — as child support rather than alimony.
These are just some of the tax planning issues that could be important in a divorce situation. Contact us today, as always, we’re available for planning assistance.