There are roughly 2,400 divorces each day of the year, breaking down to one every 36 seconds. Couples in their first marriage has a 41% chance of failure. Major life events, such as ending a marriage, impact every aspect of your financial life, including retaining assets, debt obligations, and taxes.
There are 7 key tax areas which directly affect a divorce agreement. Knowing the laws can help you achieve a settlement, which includes consideration for long-term tax consequences. Meeting with a tax attorney, in addition to a divorce lawyer to address your circumstances will help you make sound financial decisions when facing a divorce.
Tax Filing Status
An important question when filing taxes is status. If you are separated but have not finalized the divorce by December 31, of the tax year, you must file either a joint return or married filing separately. After the finalization of the divorce, you can no longer file a joint return and must either file as a single or head of household. The IRS establishes your status as of December 31, for tax purposes.
After the divorce, you may claim head of household if you have a qualified dependent living with you for more than half the year and you paid for more than half of the cost of support. There are times when you can file as head of household even if your children live with your ex-spouse.
Support Can Be Deductible
Child support is not deductible, but alimony is. You qualify for the alimony deduction even if you do not itemize. However, the IRS only considers payments made through a legal divorce agreement. The partner receiving alimony payments must also pay income tax on the money received.
The custodial spouse does not report child support as income and the paying spouse cannot deduct the cost of payments, making it non-taxable income. The IRS may disqualify alimony scheduled to end within six months of a dependent child’s 18th or 21st birthday, as they may consider the funds a form of child support.
The alimony paying spouse can typically claim an additional exemption to lower paycheck withholdings, and the alimony receiving spouse might consider having additional taxes withheld each paycheck to cover taxes due from alimony income. The other option is to make quarterly tax payments to prevent underpaying the IRS.
Who Claims the Children?
In most cases, the custodial parent claims dependent children on the tax return. The IRS defines a custodial parent as the person the child lives with the majority of the year and provides at least 50% of their support.
Tax benefits include additional personal exemptions, a higher standard deduction, the higher income threshold for the Earned Income Credit, the Child Tax Credit, and the Child Care Credit. Children entering college will use the custodial parent’s household income when qualifying for financial aid through the FASFA.
When parents share custody and child-rearing responsibilities, the IRS gives the claim to the parent the child lives with the most days. Spelling out the specifics for claiming dependent children on taxes, in the divorce agreement can clarify which parent claims dependents on what tax years.
The noncustodial parent may claim the dependent child if the custodial parent signs a waiver, specifying that they will not claim the dependent. Form 8332 must accompany the tax return.
In most cases, you cannot deduct the cost of legal fees connected with divorce proceedings. However, the cost of legal advice related to the tax consequence of a divorce may qualify as a deduction if you itemize taxes.
Legal fees associated with gaining alimony may also qualify as a tax deduction.
Other deductible legal costs might include preparing new titles for real estate property, investments, and other cases where you adjust the cost basis of assets.
You may deduct the cost of paying for your child’s medical costs, even if you do not have custody. The payments do not include health insurance premiums, but cover any qualified out of pocket expenses above 10% of Adjusted Gross Income or AGI. Qualified expenses can include medical bills not covered by insurance, dental, eye care, and some over the counter medications.
Transfer of Assets
The recipient of the assets divided due to a divorce typically does not pay taxes on the transfer. When you later sell the asset, you pay capital gains on the appreciated value, based on the original buy date. When determining whether a sale will trigger long or short-term gains, also typically uses the original purchase date, not the transfer date.
Selling the primary home before the finalization of a divorce generally allows you to avoid taxation on the first $500,000 in profits. Couples can claim the deduction whether you file jointly or separately.
When one partner buys the other partner out to keep the home, the tax-free deduction falls to the first $250,000 in gains. After a divorce, each owner can only claim the $250,000 exemption from taxation if you live in the home for two of the last five years, often disqualifying the departing partner from the deduction.
For the individual making the mortgage payments, you can include mortgage interest, when itemizing taxes. In most cases, you can also deduct the cost of property taxes and interest paid on a second mortgage or equity line of credit secured by the home.
Transferring Retirement Assets
Moving money out of retirement accounts to settle a divorce can become a taxable distribution, if not done correctly. Current laws allow you to transfer retirement assets, due to a divorce settlement, without incurring a tax penalty, regardless of your age. In most cases, when you remove assets from a retirement account, you not only pay taxes on the full balance, but also incur a 10% penalty for anyone under 59 ½.
Instead of taking a withdrawal, transfer assets under the qualified domestic relations order (QDRO), which transfers the funds to the ex-spouse without triggering tax payments or penalties for either party. You may use the QDRO form for transfers of 401K, IRAs, or other accounts earmarked for retirement.
There are many financial considerations when finalizing a divorce. Decisions around the division of assets, who will care for dependent children, and when to finalize the paperwork can impact taxation.