Tax Implications of Divorce and Support
Tax Implications of Divorce, Equitable Distribution, and Support Orders
When a husband and wife separate or divorce, a topic which is often overlooked by the parties is the impact of the separation or divorce upon each spouse’s tax obligations. With regard to the filing of tax returns, consideration should be given as to the filing status of each spouse, whether the spouses will itemize or use standard deductions if filing separately (both must use the same method), and which spouse will be entitled to claim certain deductions or exemptions. Mothers and fathers who have never married or are now divorced should also consider and negotiate the various exemptions and deductions that are available as a result of their parenthood. When negotiating the terms of an equitable distribution settlement, each spouse should consider the tax impact of being awarded certain assets especially if the assets will be liquidated. Another consideration for those individuals paying or receiving any form of spousal support, alimony pendente lite, or alimony should be the tax impact of the payment or receipt of such monies.
Filing Status For Separated Spouses
Separated spouses should objectively determine the financially best way to file their taxes. Normally filing a Married, Filing Joint Return will result in the lowest taxes; however, in doing so there must be a prior agreement on the contributions each spouse will make to any taxes owed and how the spouses will divide any refund. Separated spouses will qualify to file under the Married, Filing Joint tax status until the year the divorce decree is entered. In the alternative, separated spouses may elect to file returns under the married filing separately status. When filing separately, both spouses must either take the standard deduction or both must itemize. Although the benefit in filing separately is only being responsible for taxes associated with your income, negatives include higher tax bracket and the fact that some credits and deductions are disallowed. You should consult with a tax professional to determine which method is more advantageous.
Liability for Taxes Owed
If both spouses’ names and signatures appear on a state or federal tax return, both are liable for the taxes. If a couple files jointly, the Internal Revenue Service generally holds each spouse responsible for the entire debt. This means that if the IRS conducts an audit and one spouse failed to accurately report their income or pay their income taxes, the other spouse could be liable for the taxes owed on a jointly filed tax return!
In some circumstances, a spouse who signed a joint tax return can be excused from liability if the spouse can prove that he or she is an innocent spouse. A wife or husband can be considered an innocent spouse if he or she did not know–and had no reason to know–that the tax return understated the true tax or that the incomes or other information on the return were inaccurate. If a married person wants full protection against possible liability for inaccurate tax returns filed by his or her spouse, the best approach is to file a Married, Filing Separate return.
It is wise to have an agreement in advance which sets forth which party will claim the various deductions and exemptions so as to avoid confusion at tax filing time. Parents of minor children should consider which parent will be entitled to claim the dependency deduction for the children. Without an agreement or order of court, generally the parent with primary custody is entitled to claim the children. However, in many circumstances it makes good financial sense to award the dependency exemption to the non-custodial parent thereby increasing his or her net income and therefore the amount of support they are obligated to pay. Under certain circumstances, the amount of your legal and accounting fees paid which can be attributed to obtaining support may be tax deductible.
Earned Income Credit (EIC)
If your earned income and adjusted gross income is less than $36,052 ($41,132 if filing a joint return) with one qualifying child, or less than $40,964 ($46,044 if filing a joint return) with more than one qualifying child, or $13,660 ($18,740 if filing a joint return) if you do not have a qualifying child, you may be eligible for the earned income credit. You may not claim the EIC if you file married filing separately. See IRS publications for additional qualifications.
Child and Dependent Care Credit
A parent may be able to take this credit if that parent paid someone to care for his or her child. Parents who pay child support under an order that includes his or her contribution for day care should consult with a tax professional regarding whether they may take the child care credit. You cannot claim this credit if you file married filing separately.
Child Tax Credit
The child tax credit can be up to $1,000 per child. To qualify for the credit you must have at least one qualifying child. According to the IRS a qualifying child for the purposes of the child tax credit is a child who:
- is claimed as your dependent and
- was under age 17 at the end of the tax year and
- is your son, daughter, adopted child, stepchild grandchild or foster child and
- is a US citizen or resident alien.
- there are other requirements related to how much time the child spends in you household. You should consult with a tax professional regarding whether you are entitled to claim this credit.
Spousal Support, Alimony pendente lite, Alimony, and Child Support Orders
If you either pay or receive spousal support, alimony pendente lite, or alimony you will need to be concerned with the potential tax ramifications of these sums. If a spouse receives spousal support, APL, or alimony, the amount received usually is treated as income to the recipient and a deduction from income of the person paying the money. Furthermore, if one of these orders also contains an additional amount for child support, the entire amount received, including the child support component, may be considered income to the recipient for tax purposes unless the order of court states otherwise. If the order is solely for child support, there are no tax consequences for the receipt or payment of the money.
TAX CONSEQUENCES OF EQUITABLE DISTRIBUTION ORDERS AND MARRIAGE SETTLEMENT AGREEMENTS
The Marital Residence
Most often, the marital residence is the most expensive jointly-owned asset. Divorcing couples can sell the home now and divide the proceeds immediately, do this at a future date, or have one spouse buy out the other’s interest in the property. The parties may qualify for an exclusion of the gain associated with the sale. Married tax payers may qualify for a $500k exclusion if: 1. joint return filed for year of sale; 2. at least one spouse has owned residence for two out of 5 prior years; 3. both parties satisfy a 2 out of 5 years use requirement; or 4. various other requirements are satisfied.
If the marital residence is going to be sold, property transfer taxes are generally paid by the person selling the house. If either spouse knows that a sale may be required because they cannot financially afford to maintain the marital residence, it is best to sell the marital residence prior to the finalization of the divorce so that both spouses share the expense of the transfer taxes and other costs associated with sale.
The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
Typically, if a person borrows money from a commercial lender and the lender later cancels or forgives the debt, a taxpayer may have to include the cancelled amount as income for tax purposes and pay income taxes on that amount. Generally, the lender will report the amount of the cancelled debt to the taxpayer and to the IRS via a Form 1099-C. However, there are several exceptions to this rule which allow a taxpayer to avoid having to pay income taxes on the debt forgiven or cancelled.
One important exception to his rule was created by the Mortgage Debt Relief Act of 2007. Under the Act, a taxpayer is not required to report the cancelled debt as income when it resulted from indebtedness related to a qualified principal residence. Generally, debt reduced through mortgage restructuring as well as mortgage debt forgiven in connection with a foreclosure qualifies for this relief. This relief applies to qualified principal residence indebtedness forgiven in calendar years 2007 through 2012 and allows a maximum exclusion of $2 million dollars ($1 million dollars if filing under married filing separately status). In the event a taxpayer qualifies for this relief and excludes the forgiven or cancelled debt from their income, they must still report it on a special form that must be attached to their tax return. Seek the advice of tax expert for specific requirements in order to qualify for this relief.
Mutual Funds, Stocks, Bonds, Artwork and Other Appreciating Items
Many couples collect items during their marriage that will need to be divided during the course of a divorce. If any of these items are appreciating assets, their division should be carefully considered in light of the capital gains tax. For example, suppose a couple purchased stock some time ago for $50,000 and now, after accumulating value, it is worth $100,000. Because of a divorce, this stock is sold and divided. The capital gains tax would be applied to the profit the stock generated since its purchase, in this case $50,000.
On the other hand, suppose one spouse wants to keep the stock. In this case, they must purchase the other spouse’s share and then pay the other spouse $50,000. This makes the buyer’s total investment into the stock shares $75,000. However, for capital gains tax purposes, it doesn’t matter that the buyer actually invested $75,000; the government will consider the original cost basis of $50,000 in determining any capital gains tax. Meanwhile the $50,000 paid to the other spouse goes to them tax-free.
Often, retirement accounts are the second largest marital asset. Tax laws regarding qualified retirement plans like 401Ks are very strict and govern not only who receives the distributions, but also how they are handed out.
When divorce occurs, your ex-spouse may be entitled to some portion of your retirement plan. Divorcing couples must usually draft a Qualified Domestic Relations Order (QDRO) in order to distribute the non-participating spouse’s share of the retirement plan.
IRAs function somewhat differently than qualified plans. If there have been contributions during your marriage, your spouse will have rights to some of the IRA assets. Such assets can be transferred tax-free by a written divorce decree. If you are the recipient of transferred IRA assets, be sure to have the funds rolled immediately into your own IRA. If you don’t, you could be hit with a 20 percent withholding penalty for federal income tax.
CONSULT A TAX PROFESSIONAL
Please consult a tax consultant familiar with family law issues before relying on any information contained in this website. IRS Rules and Regulations change frequently and the information listed may be inaccurate according to the latest IRS amendments.