Consider These 7 Critical Tax Issues Pre & Post Divorce
“In this world nothing can be said to be certain except death and taxes.” – Benjamin Franklin, 1789
We’ve all heard it. Some of us have even said it. This famous adage has been repeated time and time again through the centuries as a fatalistic observation that describes something both inevitable and unavoidable.
While the concept of death seems simple enough, the passage of time has proven that taxes continue to become more and more complicated. Taxes are a complicated concept to many even on a basic level. To anyone facing the prospect of a divorce (which can feel like a death), taxes are certain to be even more muddled.
To help clarify some of the tax-related issues related to a divorce, there are several points to consider both before and after your divorce is finalized.
Key Tax Considerations Prior to Finalizing Your Divorce:
1. Consider the tax implications of child support and alimony – Child support and alimony might be the most contentiously debated issue in any divorce. It can be challenging to strike the right balance between ability to pay, the marital standard of living, each spouse’s lifestyle needs, and ultimately, the child custody schedule. Each has a great effect on the bottom line.
There was a big change in tax law around alimony thanks to the Tax Cuts and Jobs Act of 2017. While child support is not tax deductible to the spouse who pays it and is not taxed by the spouse who receives it, alimony payments are now no longer tax deductible to the payer or taxed as income to the recipient. This new tax treatment heavily influences the amount of support that is ordered by the courts, and what level of support is considered “reasonable” during mediation or settlements. If you have been paying alimony for many years and your divorce was finalized before 2019, you are “grandfathered” under the old rules – you’ll still deduct the payment from your tax return and your ex-spouse will continue to pay tax on that payment as income.
If you rolled your alimony and child support together into “family support” in your agreement, it will be fully taxable to the recipient and deductible to the payer, just like alimony. The court order does not specify how much of the family support order is for child or spousal support. This is a very meaningful difference when you compare family support to child support – family support is deductible for state tax purposes and child support is not. Divorces finalized prior to 2019 are grandfathered under the old rules.
2. Determine the best way to transfer property – When couples are divorcing, property transfers between the two parties generally occur with no tax consequence to either side. However, it may make sense to forego the tax-free treatment that the law affords divorcing spouses for property transfers, and instead intentionally create a taxable event by structuring the transaction as a “true sale” more than one year after the divorce is finalized. This could allow the spouse who purchases their ex-spouse’s share of the family residence to benefit from an increased cost basis on the property.
Example: Assume a couple in California purchased a home for $1,000,000 and five years later they are divorcing with the home now worth $1,300,000. If they have a mortgage on the property for $700,000, then the equity in the home would be about $600,000. At this point, “tax Impacting” the home would conclude that if the wife was the one keeping the home and she was to sell it at $1,300,000, she would receive the first $250,000 of gain free of tax due to the capital gains exclusion on the primary residence – she would owe federal and state taxes on the remaining $50,000 of gain, thus costing her about $16,700 (assuming a 20% federal capital gains tax and a 13.3% California State tax). If the wife wants to stay in the home and takes this asset onto her side of the balance sheet, then she would need to give her (soon to be) ex-husband other assets totaling $583,300.
But what if you structured this property exchange as a purchase instead? The wife could “buy” the home from the community and both parties could benefit from the tax savings. If the community were to “sell” to the wife, then both spouses’ capital gain exclusions would be in play. Not only would no taxes be due on the “sale” of the home, but the “new” cost basis of the home to the wife would be $1,300,000- thus reducing her potential capital gains tax liability in the future.
Before tapping into the tax break suggested in this example, you should consult with your CPA and/or attorneys – resetting the tax basis also means resetting the property tax basis. While the wife may save money on the capital gains tax in later years once she ultimately sells the home, the annual property tax bill will likely increase based upon the new sales price.
3. Make sure you handle retirement accounts carefully – In order to transfer all or part of a qualified retirement plan as part of a divorce settlement, a court must issue a qualified domestic relations order (QDRO). There are no tax consequences if the transfer is structured appropriately as an eligible rollover distribution. When receiving a portion of a former spouse’s retirement account under a QDRO, the recipient needs to decide whether to keep it in the existing plan or whether to roll the funds into an IRA. QDROs do not govern the division and transfer of IRA assets. However, it’s very easy to transfer IRA dollars using a trustee-to-trustee (direct) transfer with no tax consequences – you simply open an IRA for the other spouse’s benefit and provide a copy of the divorce decree to the custodian (the bank that holds the accounts). To be exempt from taxes and early withdrawal penalties, such transfers must be handled in accordance with IRS regulations.
4. Know who is claiming the children as tax credits – Only one spouse is able to claim the children as tax credits after the divorce, so determine which spouse would derive the greatest benefit from that deduction and then look to share the benefit. Most often it is the parent who spends the most time with the children that claims the children on their tax return as dependents. If you instead allow the parent who has the highest adjusted gross income (who makes the most money net of deductions) to claim this tax credit, more money will be saved instead of spent on taxes.
Key Tax Considerations After Your Divorce is Finalized:
1. Another word about claiming the children as tax credits – The first spouse to file their tax return will get to claim the children, and the burden of proof regarding whose right it actually is to claim them falls to the second filer. If you are worried your ex might try to take the “dependent deduction” that you are in fact entitled to, be sure to file early so you don’t wind up fighting for your right to that deduction with the IRS. Trying to work out issues with your tax return through the IRS might be the only thing worse than working out all the issues with your ex through your divorce.
2. Claim Head of Household if You Have a Child – If you are considered single on the last day of the year (whether divorced or legally separated), you can take a higher standard deduction by claiming Head of Household. You can claim the Head of Household status if you have custody of your children for more than half the year….even if your ex-spouse is already claiming the children as dependents on his/her tax return. Under the new tax law, the standard deduction is $18,000 for Head of Household compared to $12,000 for single filing status.
3. Know that you could still be audited – Just because your prior years’ tax returns are filed and already forgotten about, remember that you and your ex could still be audited together on those joint tax returns that were filed up to three years ago. Be ready to cooperate and do your part to provide information or documentation to support the figures you filed to the IRS.
It’s safe to say that even our nation’s Founding Fathers could not have anticipated the complexities of our current tax system. Still, Benjamin Franklin was prescient enough to recognize the certainty of taxes. With the awareness that taxes can and undoubtedly will play an important role in a divorce, it’s best to engage a professional to help you plan for the best possible outcome.
The information contained herein is not personalized. You should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice.