Divorce & Taxes: Answers to Nine Common Questions
If you are in the midst of a divorce, tax season can present unanticipated issues. Despite the emotions involved in divorce, always approach tax season in a logical and business-like manner to avoid unwise decisions or errors in filing your taxes.
The following are answers to nine of the questions we hear most often from our clients who are in the middle of this difficult transition.
If you are divorcing or contemplating a divorce, be sure to discuss tax considerations with your attorney early on in the process. You may also want to talk with an accountant or tax specialist. The IRS is also a great resource and has many helpful publications are available for download at www.irs.gov . The following information is current as of March 2014.
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Divorce & Taxes Checklist: 8 Important Tax Considerations for Divorcing Couples
1. For purposes of my filing, am I “married” or “single”?
Your tax filing status is determined on the last day of a tax year. Even if you are living separately from your spouse, have reached a divorce settlement, or have completed a dissolution trial, you are considered married until a Decree of Dissolution is signed by the court. This means that if no decree is entered by December 31 of the tax year, you are considered married for tax purposes.
If you are married
If you are legally married for a given tax year, you and your spouse can file a joint tax return (“Married filing jointly”) or you can each file your own separate tax return (“Married filing separately”).
- Joint Tax Return. Usually a joint tax return is more tax advantageous for both spouses. However, be aware that you may have joint liabilities. Whether you or your spouse prepares your return, be sure to review it and all supporting documentation carefully. You may also want to hire an independent accountant to review any return before you sign it.
- Separate Tax Return. If you and your spouse choose to file separate tax returns, each of you is responsible for your own return. Be aware that you will likely pay a higher tax, due to your tax rate and limitations on the credits and exemptions you can take. If your spouse itemizes deductions, you cannot use the standard deduction and must itemize, as well. Finally, make every effort to coordinate your return with your spouse’s to ensure that income, deductions and credits are claimed and recognized correctly.
If you are single
If you are legally single by December 31, you must file a separate return as a single tax payer for that tax year. This is true even if you were married for the majority of the tax year.
Claiming Head of Household (“HOH”) status may lower your tax obligation. If you and your spouse file separate returns, one of you can claim HOH status, regardless of whether you are officially single or married. If you are single, you qualify for HOH if (1) you paid more than half the cost of keeping up a home in the tax year and (2) a child or other qualifying person lived with you in the home for more than half the year. If you are still considered married, you may qualify for HOH status if you meet the preceding criteria and (a) you paid more than half the cost of keeping up your separate home in the tax year; (b) your spouse did not live with you for the last six months of the tax year; (c) your home was the main home of your child for more than half the year; and (d) you can legally claim an exemption for your child.
If you have any dependent children, you may be entitled to claim an exemption on your tax return, if the child lives with you most of the time. Additionally, you and your spouse can agree to trade exemptions (and/or divide the exemptions if you have more than one child) from year to year. If your income is significantly higher than your spouse’s, you may find it more advantageous to claim all exemptions. Be aware, that at high levels of income, the exemption phases out, and the amount you can claim is reduced.
If you are the custodial parent of a child, you may be entitled to claim certain tax credits. These credits are different from exemptions and cannot be traded or divided by agreement. Click here to see if you now qualify for the following tax credits.
Earned Income Credit
The earned income tax credit is intended to assist people with low-to-moderate incomes. The earned income tax credit is one of the most heavily audited tax credits, so it is a good idea to seek professional assistance if you wish to claim this credit.
Child Tax Credit
This credit may allow you to reduce the federal income tax you owe by up to $1,000 for each child under the age of 17. This credit is phased out at fairly low income levels. You may, however, be able to obtain a credit even if you do not owe any taxes for a given year.
Child Care Credit
If you are the parent of a child under the age of 13 and you paid someone to care for your child while you were at work or looking for work, you may be able to claim a credit on your tax return.
Maintenance vs. Child Support.
Regular cash payments you make to your spouse or former spouse under a divorce or separation instrument (such as a Decree of Dissolution, separation agreement, court order, etc.) are usually considered “spousal maintenance.” Any maintenance you receive must be reported as income on your return. Any maintenance you pay can be deducted on your return.
Child support, on the other hand, is neither taxable to the recipient nor tax deductible for the payer.
Payments designated as not alimony
There is an exception to the standard tax treatment of alimony. From IRS Pub. 17, note the following:
“ Payments designated as not alimony. You and your spouse can designate that otherwise qualifying payments are not alimony. You do this by including a provision in your divorce or separation instrument that states the payments are not deductible as alimony by you and are excludable from your spouse’s income. For this purpose, any instrument (written statement) signed by both of you that makes this designation and that refers to a previous written separation agreement is treated as a written separation agreement (and therefore a divorce or separation instrument). If you are subject to temporary support orders, the designation must be made in the original or a later temporary support order.
Your spouse can exclude the payments from income only if he or she attaches a copy of the instrument designating them as not alimony to his or her return. The copy must be attached each year the designation applies.”
Maintenance Recapture Rule.
If you pay spousal maintenance and the amount you pay decreases or terminates during the first three calendar years (not including payments you made under a temporary maintenance order), you may be subject to the maintenance recapture rule. This rule requires that in your third year of regular payments, you must include as income part of the maintenance payments you previously deducted on your return (your spouse receiving maintenance can make a corresponding deduction in the third year). The recapture rule usually arises when you change your divorce/separation agreement or final order with respect to the maintenance you pay. Recapture issues can also come up if you fail to make your required maintenance payments or if you reduce the maintenance you pay for some other reason.
Property and cash transfers between you and your spouse made as part of a divorce agreement are generally tax neutral. This means that there is no tax on cash transfers, there is no gain or loss on property transfers, and the basis of a transferred asset will not change. If you receive property that produces after divorce income (such as rental property, stocks, or business interest), you are required to report income you receive from that asset on your return. Special rules apply if you transfer more complex assets, such as assets with unused passive activity loss, investment property with recapture potential, stock options, and deferred compensation. If you transfer these assets, you may end up with an adjusted basis, recognition of income, or recapture issues.
7. How do I handle dividing the assets in our retirement plans and the taxes associated with those plans?
Your individual retirement benefits can be divided as part of your final divorce. In most cases you will pay no tax at the time of transfer.
- If you have a qualified retirement plan, such as a pension plan or 401(k) account through your employer, your plan/account would be divided by a qualified domestic relations order (“QDRO”). A QDRO is a court order which instructs the plan to divide the benefit and ensure that the recipient spouse will pay taxes on any distributions.
- If you have an Individual Retirement Plan (“IRA”), you can divide it tax free in your divorce by using an IRA Transfer Order. After transfer, the IRA is treated as the recipients’ own IRA account with all the resultant tax benefits and consequences.
Unfortunately, you cannot deduct the legal fees and court costs you incur in your divorce from your taxes. However, you may be able to deduct legal fees and costs you pay in your effort to obtain spousal maintenance. You may also be able to adjust the basis of real property by adding fees you pay to prepare and file a deed of trust on that property as part of your divorce settlement.
Tackling your tax issues “up front” in your divorce settlement agreement or Decree of Dissolution will save significant frustration (and legal fees) come tax time, especially if any of these issues arise several years after your divorce is finalized. Make sure you address division of future child tax credits and exemptions, recognition of current or past income, division of refunds for past returns, liability for past returns, and any tax consequences on the sale of the family home.
Please be advised that legal and/or tax issues can be very complex and are different for everyone, based on unique circumstances. The information provided here is informational only and should not be construed as personal legal or tax advice. Consult an attorney or tax specialist for advice on your situation.