Divorce proceedings pose numerous tax percussions which offer challenging planning considerations for separated and divorced taxpayers, including the change in filing status and the treatment of certain income and deductions related to children, alimony, property transfers and the marital home. Thorough consideration of the tax treatment is essential for negotiating equitable divorce settlements.
Tax Tip – Attorney’s fees and related expenses allocable to the collection of income and tax advice are deductible.
Married taxpayers have the option of filing a joint return or each filing their own separate returns. Generally, filing jointly produces a lower aggregate tax, while filing separately may be advantageous to one spouse. Joint filers are jointly and severally liable for all income tax, related penalties and interest, including later determined deficiencies, subject to innocent spouse relief.
Tax Tip– Spouses who have filed separately can make a claim for refund by changing to a joint return within three years of the due dates of the separate returns.
Only individuals who are married at the close of the tax year may file a joint return. Spouses legally separated under a decree of divorce or separate maintenance are not considered married for tax purposes. If a taxpayer is unmarried, he or she must file as a single taxpayer unless he or she meets the requirements for filing as head of household, which has lower marginal rates.
Tax Tip – A married taxpayer with a dependent child, whose spouse was not a member of the household during the last six months of the year, may file as head of household as an abandoned spouse, by furnishing more than half the cost of maintaining a home (for over half the taxable year).
Generally, the child of a divorced or separated parent qualifies for the dependency exemption of the parent that he or she resided with for the longer period of time during the tax year (known as the custodial parent).
Tax Tip– The custodial parent may waive the exemption in favor of the non-custodial parent in a higher tax bracket, resulting in tax savings that can be passed along in the form of child support.
Parents may not split the tax benefits arising from the dependency exemption (such as the child tax credit and dependent care credit), although, in the case of more than one child in the family, each parent may claim a different child. In contrast, where a student is a claimed a dependent, qualified tuition and related expenses paid by the student are treated as paid by the taxpayer, even if paid by a third party.
Tax Tip– The custodial parent who claims their child as a dependent may claim an education tax credit for qualified expenses paid by the non-custodial parent on behalf of the student.
Alimony is a form of support which is taxable to the payee spouse and equally deductible to the paying spouse, making alimony a useful tool in shifting income to the spouse in the lower tax bracket. Additionally, alimony payments can be made to third parties for the benefit of the payee spouse, enabling support agreements to be fully deductible, where they may otherwise be limited.
Tax Tip– Medical expenses and certain costs to maintain a home paid on behalf of the payee spouse can be fully deductible as alimony, rather than as an itemized deduction, which is subject to limitations.
In contrast, payments representing child support are neither includible in the income of the payee nor deductible by the paying spouse.
Generally, no gain or loss is recognized on a transfer of property from an individual to a spouse or former spouse if the transfer is incident to a divorce. Non-recognition applies even where the parties are acting at arm’s length and the transferee spouse pays full consideration for the property.
Tax Tip – In deciding how to divide their assets, the parties should consider allocating assets with greater potential gains to the spouse in the lower tax bracket and allocating assets that have appreciated little or have declined in value to the spouse in the higher tax bracket.
For retirement accounts, a spouse or former spouse of an employee may receive a tax-free rollover distribution from that employer’s qualified retirement plan as part of a court-approved property settlement.
The non-recognition rule applies to a spouse’s transfer of the martial home incident to divorce. If the home is later sold to a third party, gain up to $250,000 can be excluded from gross income, provided the spouse has owned and used the home as his or her principal residence for periods aggregating two of the five years immediately prior to the sale.
Tax Tip– With proper planning, the divorcing couple can shield up to $500,000 in gain from the sale of their principal residence where (though living apart) one spouse’s continued use of the residence is a condition of the divorce agreement.
The tax savings in a proposed settlement which obligates one party to pay debt and taxes on the former marital home (providing for significant tax deductions to the paying spouse) should be used as leverage in negotiations.