There’s a lot going on in a divorce. You might be paying or receiving alimony and child support. The marital home, retirement funds, and businesses may be sold or transferred. It will be determined who gets what tax benefits for the children. Your tax filing status will change. Taxes affect every divorce. This chapter will view various divorce transactions from the tax point of view. You may use it as a checklist for tax issues in negotiations, settlement, and litigation.
Your marital status on the last day of the year, December 31, determines your filing status for federal income tax. And your filing status determines which tax rates apply to your income.
Married Filing Jointly
If you are married on the last day of the year, you can file a joint tax return with your spouse and your status will be “Married filing jointly.” This filing status has the lowest tax rates. Even if you are separated, you can still file joint tax returns to take advantage of the lower tax rates.
Married Filing Separately
If you file separate tax returns, your status will be “Married filing separately.” This filing status has the highest tax rates. Let’s listen in on a conversation that will show you the types of disputes that may arise over tax-filing status in a divorce. The conversation takes place at the offices of the wife’s lawyer during the deposition of the husband with both spouses and their lawyers present.
Randy asks his wife, Susie, “Are you going to sign the joint tax return?”
Susie’s lawyer, Gloria, responds for her: “Since you are working and Susie is not, we calculate that you will save $10,000 in taxes by filing a joint return.”
“So?” says Randy.
“Susie won’t owe any taxes whether she files jointly or separately,” says Gloria. “So, we propose that Susie will file jointly with you if you agree to pay her $5,000 of your tax refund.”
“Why, that’s blackmail!” shouts Randy. He stands up and walks out.
Randy’s lawyer looks at Gloria and says, “Let’s talk. Maybe we can work something out.”
When one spouse has a higher income than the other, that spouse may gain a significant tax savings by filing jointly. However, when spouses are divorcing, sometimes anger gets in the way of their commonsense (and common cents). The high-income earner may have to share some of the tax savings with the low-income spouse to get an agreement to file joint tax returns.
Tip If you and your spouse file jointly, you cannot file amended separate tax returns later. But if you file separately, you can file an amended joint return if you reach a settlement after filing your taxes.
Single
If you are not married on the last day of the year, you may file your tax returns as “Single,” which has the third-lowest tax rates.
You can still file your tax returns as single even if you are married on the last day of the year if you meet all of the following conditions:
- You and your spouse file separate returns;
- A child lives for more than half a year at your home and you are eligible to claim him as a dependent;
- You provide more than half the cost of maintaining your home during the year; and
- Your spouse did not live in the same house during the last six months of the previous year.
Head of Household
If you are not married on the last day of the year, you can file as “Head of household,” which has the second-lowest tax rates, if you meet all of the following requirements:
- you maintain the home of a qualified dependent for more than half the year;
- you pay more than half of the cost of the home for the qualified dependent;
- your spouse or former spouse is not a member of your household; and
- you do not file a joint return.
If you have one child, only one parent can qualify for the head-of-household status because of the requirement of furnishing more than one-half of the support of the household for a qualified dependent. If you have more than one child, both parents can meet the terms for the status.
Tip Your marital status on the last day of the year determines your filing status. There are different tax rates for each status. “Married filing jointly” is the lowest status, and “Married filing separately” is the highest.
Alimony is tax deductible if you are paying it and taxable income if you are receiving it. There is no withholding tax on alimony income so you may have to make estimated tax payments quarterly if you receive alimony. If you forget to do this, and many people do, you will have a big tax bill on April 15th.
Child support, by contrast, is not deductible for the person paying it, and it is not taxable income for the person receiving it. So a high earner will be better off paying more alimony and less child support due to the tax deduction for alimony. And the person receiving payments will be better off with more nontaxable child support and less taxable alimony.
The Internal Revenue Code requires that payments meet all of the following conditions to be deductible as alimony:
- they must be made to or on behalf of a spouse or former spouse;
- they must be made in cash or a cash equivalent;
- they must be pursuant to a written divorce agreement or order;
- the agreement or order does not say the payment is not alimony;
- the parties do not live in same household;
- the payments terminate upon the death of the person receiving alimony;
- they are not made in a year for which the parties file a joint return;
- they are not for child support; and
- they are not disqualified under the IRS alimony recapture rules.
Here’s an example: When David and Sue agreed to separate in January, David agreed that he would continue to be the breadwinner and support the family by paying Sue $5,000 a month. He paid her $60,000 during the year.
David asked his accountant if he could file a separate tax return for the year and deduct the $60,000 he had paid as alimony.
The accountant told him no, because the payments were not made under a written divorce agreement. David could have saved thousands of dollars if he had only put the agreement in writing.
Fortunately for him, Sue agreed to file joint returns for that year. Had she not, David would have had to pay the higher tax rates for filing as “Married filing separately,” and he would not be able to take the alimony deductions that he would have had if he had a written agreement.
There are tax complications for the spouse who receives alimony as well. An example is the Earned Income Credit, which phases out as your income rises. Alimony may increase your income to the point that you lose the Earned Income Credit.
Tip Even if you call it alimony, it may not be deductible unless you meet the IRS requirements for alimony.
The IRS has rules designed to prevent you from turning nondeductible child support payments into deductible alimony payments, discussed in the earlier chapter on alimony. Basically, since child support ends when a child becomes an adult, these rules disallow deductions for alimony payments that are tied to an event in the child’s life.
Alimony vs. Property Transfer
The IRS also has rules to prevent you from turning a nontaxable property transfer into deductible alimony. These rules were discussed in detail in the chapter on alimony. They allow the IRS to recapture deductions for alimony payments that are front end loaded into the first two years of alimony payments.
There are favorable tax benefits associated with owning a family home, including tax deductions and exclusion of some capital gains on a sale. You need to consider these tax benefits in a divorce.
A taxpayer may deduct interest she paid on mortgages and real estate taxes for her primary residence. She may also take those deductions after she moves out of the family home if she still has a dependent living in the home.
If you have a divorce agreement or divorce order that gives the use and possession of a jointly owned home to your spouse and requires you to pay all of the mortgage and taxes, you are entitled to deduct half of these payments as alimony plus half of the interest and taxes.
If the home is in your name alone, however, you can deduct all the interest and taxes, but there is no deduction for alimony because you are paying your expenses and not those of your spouse.
Sale of a Home
Upon the sale of a home, you may exclude up to $250,000 in gain from your income and your spouse can also exclude up to $250,000. Gain is the sales price less your tax basis. Tax basis is costs plus selling expenses and improvements minus any depreciation you have taken for tax purposes.
The home must be your principal residence. A principal residence is defined by the IRS as a home you’ve owned and lived in for at least two of the five years before the sale. There are exceptions to this rule for military members, vacation homes, homes bought less than two years prior, and certain hardships and other circumstances.
If you reach an agreement to sell the house at the time of divorce, then you will be able to exclude up to $500,000 of gain from your taxes if you meet the personal residence requirements.
But if you buy out your spouse in a divorce, that transfer will be tax free for both of you. Your spouse won’t pay any capital gains tax. If you stay in the house and sell it later, you can exclude $250,000 of the gain as long as the house qualifies as your personal residence.
Here’s an example: George and Jill lived in their house for twenty months before they divorced. In the divorce, the court granted Jill the right to live in the house for three more years or until it was sold, whichever came first. They would continue to own the house together and split the proceeds when it was sold. Jill sold the house a year later. Since she had lived in the house for more than two years, she was entitled to the $250,000 tax exclusion.
What about George? He had only lived in the house for twenty months at the time of the divorce, less than the two years required for the exclusion. Fortunately, the IRS permitted him to tack on to his time the period that Jill was living in the house exclusively under the divorce decree. So George would also get the $250,000 exclusion. Note that he could have lost his exclusion entirely if he had not obtained a written agreement or divorce decree within three years of moving out of the house. That is because he would not have lived in the house for two of the prior five years and could not tack on Jill’s time because it was not pursuant to a divorce decree or instrument.
Tip You can deduct up to $250,000 of gain from the sale of your home if you meet the IRS tests for ownership and use.
All Property Transfers in Divorce Are Tax Free
Property transfers from one spouse to another in a divorce are nontaxable events. You do not report any gains or losses on the transaction in your tax returns.
Your tax basis is transferred to your spouse with the property. The tax basis is the cost of the asset with certain adjustments provided by the tax code like selling costs and depreciation. When you sell the asset, that is a taxable event. The sales price less the tax basis is your capital gain or loss for tax purposes.
Jeff and Lisa were in the process of getting divorced. As part of their property settlement, Jeff agreed to pay Lisa $50,000. During their marriage, they had purchased some Apple stock together for $10,000. The stock was now worth $100,000. If Lisa were to transfer her half of the Apple stock to Jeff, would she be paying him $50,000? Maybe not. If Jeff were to try to turn the stock into cash by selling it, he would have to pay taxes on the capital gains. The capital gains are the sales price of $50,000 less the original cost of $5,000, which equals $45,000. If the taxes are 20 percent of his $45,000 in capital gains, he will owe $9,000 in taxes on the stock sale. Due to the tax consequences, Jeff would be better off insisting that Lisa pay him $50,000 in cash instead of stock.
Tip Property transfers in a divorce are tax free, but not all assets are equal due to the tax consequences when they are sold later.
Retirement funds in qualified pension plans and traditional individual retirement accounts are not taxed when they are earned; they are taxed when the funds are withdrawn. There is no tax on the transfer of retirement funds pursuant to a divorce order. But retirement funds carry an income tax burden with them like the previous stock example. And this income will be taxed at ordinary income rates, which may be higher than the capital gains rate.
401(k) Plans
The division of 401(k) plans is done tax free with a Qualified Domestic Relations Order issued by the divorce court. The plans continue to earn interest and dividends tax free until they are withdrawn. When withdrawn, they are taxed as earned income. If a person withdraws funds from a 401(k) before they reach age fifty-nine-and-a-half, they are subject to a 10 percent penalty tax. There is one important exception to the 10 percent penalty rule. Here’s an example to illustrate the exception.
Carlos, Helen’s divorce attorney, was young, tall, and thin. He was dressed impeccably in a dark-navy suit, white starched button-down shirt, and red tie for his meeting with Steve, the divorce attorney of Helen’s husband, Nelson.
Steve was a short, slightly pudgy man, with wisps of grey hair framing his bald head. Carlos went to the other lawyer’s office for the meeting.
“The problem Helen has with your client’s settlement,” Carlos tells Steve, “is that there is no money for her to make a down payment on a new place to live.”
“What about the $100,000 she’s getting from the 401(k)?” asks Steve.
“Well, she can’t use that because she will have to pay the 10 percent early withdrawal penalty,” Carlos remarks.
“Ah ha!” exclaims Steve as he jumps up from his desk. “Follow me.”
Carlos followed as Steve strode spryly out of his office and down a long hallway into another office where a young associate labored over a desk piled high with books.
“Hi Alex,” says Steve. “Can you find that little obscure provision in the Internal Revenue Code that provides that 401(k) plans can be distributed in a divorce without a 10 percent early withdrawal penalty?”
Alex grabbed his dog-eared copy of the Internal Revenue Code and thumbed through it quickly. He laid it open on the desk and pointed to a provision with the tip of his pencil.
“Here it is,” Alex tells them. “In section 72, if go all the way down to subparagraph (t), and then look below that at subparagraph (2)(C), it says that the 10 percent early withdrawal penalty does not apply to: ‘Any distribution to an alternate payee pursuant to a qualified domestic relations order.’”
“Wow!” Carlos remarks. “That’s something they never taught me in law school.”
Individual Retirement Account
Parties can transfer funds from one spouse’s individual retirement account, or IRA, to the other spouse’s IRA tax free in a divorce. You do not need a Qualified Domestic Relations Order to divide an IRA because IRAs do not fall within the ERISA requirements of the Internal Revenue Code, which govern 401(k) and other so-called qualified plans.
The institution where you have your IRA will probably want to see a copy of the divorce decree and separation agreement upon the transfer. They may have a form for you to sign requesting the transfer or they may ask you to send a letter requesting it. After the transfer is completed, the new IRA will be treated in the same as any other IRA: the taxes will be deferred until the funds are withdrawn. Note that we’re talking about transferring money in a divorce. If you actually cash out to pay off a spouse, that’s different, and it would be a taxable event. If you take an early distribution from the new IRA, you will have to pay taxes and the 10 percent early withdrawal penalty. The divorce exception to the early withdrawal penalty that we saw in the previous story does not apply to IRAs. So you will have to pay the taxes and the penalty if you withdraw the money before the age of fifty-nine-and-a-half.
Caution Distributions in a divorce from a qualified pension plan are exempt from the early withdrawal penalty but not IRAs.
You can negotiate or ask the court to decide the allocation of tax benefits associated with children in your divorce, namely the dependent exemption, the child tax credit, the child care credit, and the head-of-household filing status.
Dependency Exemption
You are entitled to take a personal exemption for your own income and for each dependent you support. An exemption works just like a deduction, by reducing your tax. The amount of the exemption for 2013 is $3,900. The exemption is phased out as your income increases for each filing status.
Beginning in 2013, the phaseout for each filing status is as follows:
- “Married filing jointly” (phase-out begins at $300,000 and ends at $422,500 of adjusted gross income)
- “Head of household” (phase-out begins at $275,000 and ends at $397,500 of adjusted gross income)
- “Single” (phase-out begins at $250,000 and ends at $372,500 of adjusted gross income)
- “Married filing separately” (phase-out begins at $150,000 and ends at $211,250 of adjusted gross income)
A custodial parent is entitled to the dependency exemption if the following requirements are met. You are a custodial parent if the child lives with you for more than half the year.
- Children and stepchildren qualify for the exemption as well as certain other dependents.
- The parents together provided more than one-half of the child’s support.
- The child was in the custody of one or both parents for a total of more than half of the year.
- The parents were divorced or legally separated by court decree, separated under a separation agreement, or lived apart for the entire last six months of the year.
- The child was either under age nineteen or the child was a full-time student for at least five months and under the age of twenty-four at the end of the year.
A custodial parent may release the dependency exemption to a noncustodial parent. This might occur as a result of negotiations in a settlement or in a case where a high-income custodial parent is phased out of the exemption and cannot use it anyway.
The release requires IRS form 8332 to be completed and signed by the custodial parent and attached to the noncustodial parent’s tax return. The release either applies to all future years or in cases where it is conditioned on child support being paid, the custodial parent may sign it for one year at a time.
Tax Planning with Dependency Exemptions
In order to qualify for head-of-household filing status and a lower tax rate, you need to have a qualified dependent. If there are two or more children, each parent should claim at least one of them as a dependent, so that both parents can qualify. Otherwise, the parent with the highest income will get the most benefit from the exemptions, unless that income is high enough to trigger the phaseout provisions.
Tip You can allocate dependency exemptions between parents in a divorce to achieve the best tax results.
Child Tax Credit
You can take a $1,000 child tax credit in 2013 for each child under age seventeen whom you claim as a dependent. This is a dollar-for-dollar reduction in your taxes (not a deduction from your income).
The child tax credit is gradually reduced as your income goes up. The phaseout begins at these income levels:
- $55,000 for married couples filing separately
- $75,000 for a person who is single and the head of a household
- $110,000 for married couples filing jointly
The child tax credit is reduced by $50 for each $1,000 of income above these amounts.
The child tax credit accompanies the dependency exemption. So if you are the custodial parent, you are entitled to this credit unless you have released it to the noncustodial parent.
Child Care Expenses
You may be entitled to the dependent care credit for child care expenses that enable you to work or look for work, such as day care or summer camp. This is available to custodial parents, and it may be released to noncustodial parents with the dependency exemption using IRS form 8832. The child must be under thirteen years of age on the last day of the year for you to qualify.
In 2013, the credit is 20 percent of your child care expenses if your adjusted gross income is over $43,000 and gradually goes up according to your income, with a maximum of 35 percent if your adjusted gross income is less than $15,000. The credit is capped at $3,000 per child.
Some employers offer benefit plans that allow employees to take part of their income as tax-free reimbursement of day care expenses. This could be more advantageous to you than claiming the dependent care credit, depending on your circumstances.
Summary
Every divorce transaction should be viewed through the lens of its tax consequences. There is no getting around the fact that the tax code is complex and complicated. That’s why we have accountants and tax lawyers. But being knowledgeable about the general principles of taxes and divorce that we have discussed in this chapter will help you as you proceed through the divorce process. Next we will talk about how to settle your divorce case.