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Worried about the Tax Consequences of Divorce? - Part 1

Worried about the Tax Consequences of Divorce? - Part 1 

BrookWeiner, LLC

This is Part 1 of a two part series.

Although most (young) people get married out of love, the reality is that over time the assets and liabilities acquired throughout the years can greatly impact the nature of the union, to where it can evolve into more like a business entity. This business perspective becomes painfully apparent when the partners in the marriage "call it quits" and the painful dissolution of who will get what and when is decided. In addition to what is already a highly emotional situation are the tax responsibilities and consequences to each spouse, which I would like to outline for your reference below.

Support provisions
Where one spouse is to be making support payments to the other upon divorce or separation, the payments are deductible by the payor and taxable to the payee if they qualify under the tax rules for "alimony." To qualify, the payments must be:
(i)
required under the divorce decree or separation agreement (i.e., voluntary or "extra" payments won't qualify),
(ii)
in cash only (not goods or services),
(iii)
required to end at the death of the recipient spouse, and
(iv) made to the parties living in separate households. The parties can elect to have payments that qualify be treated as not qualifying (but not vice versa).

Support payments for children ("child support") aren't deductible by the paying spouse (or taxable to the recipient). These include payments specifically designated as child support as well as payments which otherwise might look like alimony but are linked to an event or date related to a child. For example, say a spouse is to pay "alimony" of $3,000 a month, dropping to $2,000 a month at a specified date. If the date coincides with a child's 18th or 21st birthday, the "extra" $1,000 will be characterized as child support and not be deductible by the paying spouse (or taxable to the recipient spouse).

Tax planning for support payments generally seeks to make them deductible if the paying spouse is in a higher tax bracket than the recipient, as is often the case. The tax savings for the paying spouse can be shared with the recipient through higher payment amounts or other benefit provisions. For example, if having payments qualify as alimony will save the paying spouse $5,000 in tax and will cost the receiving spouse only $2,000 (determined by multiplying the alimony amount by the individual's marginal income tax bracket), the paying spouse can offer additional payments in the divorce negotiations to cover the recipient's tax cost and a share of the additional tax savings.

Since alimony payments are required to end at the death of the receiving spouse, as noted above, the parties may wish to provide for life insurance for that spouse as part of the arrangement.

Dependency exemptions
To some extent, the parties can determine who is entitled to claim the dependency exemption for their dependent children. The exemption for the child goes to the spouse who has legal custody of the child. However, that spouse can waive his or her right to the exemption, thus allowing the noncustodial spouse to claim it. In general, tax planning calls for the spouses to agree to have the exemption go to the spouse who can extract the greater tax benefit from it. As discussed above in connection with tax savings from support arrangements, the tax benefit can then be "shared" with the other spouse via increased support payments or in some other fashion.

The dependency exemption entitles the spouse who claims it to more than just the exemption. For example, the child tax and the higher education (Hope and Lifetime learning) credits are only available to the spouse who claims the child as a dependent. (Note, however, if the custodial parent waives the right to the exemption, the custodial parent can still claim the child care credit for qualifying expenses if the child is under 13.)

If a custodial spouse is waiving the right to the dependency exemption for a child, it's done on Form 8332. This can be done on an annual basis or one time to cover future years. Where the waiving spouse will be receiving support payments from the other spouse, the waiving spouse often prefers the annual approach so he or she can refuse to grant the waiver if support payments are late or have been missed.

Property settlements
When property is split up in connection with a divorce, there are usually no immediate tax consequences. Thus, property transferred between the spouses won't result in taxable gain or loss to the transferring spouse. Instead, the receiving spouse takes the same basis (cost) in the property that the transferring spouse had. (The receiving spouse may have to pay tax later, however, when the recipient spouse sells the property. For example, if a spouse receives a $300,000 vacation home, but the transferring spouse's basis was only $150,000, the recipient spouse will have a taxable gain if he or she later sells the house for more than $150,000, unless the spouse qualifies to exclude part or all of the gain by first making the house his or her principal residence).

Personal residence
In general, if a married couple sells their home in connection with divorce or legal separation they should be able to avoid tax on up to $500,000 of gain (as long as they owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out. If the couple doesn't meet the two year ownership and use tests, any gain from the sale may qualify for a reduced exclusion by reason of unforeseen circumstances.

Pension benefits
A spouse's pension benefits are often part of a property settlement. When this is the case, the commonly preferred method to handle the benefits is to get a "qualified domestic relations order (QDRO)." A QDRO gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them even though they are paid out to the other spouse.

A QDRO isn't needed to split up an IRA, but special care must be taken to avoid unfavorable tax consequences. For example, if an IRA owner were to cash out his IRA and then pay his ex-spouse her share of the IRA as stipulated in a divorce decree, the transaction could be treated as a taxable distribution (possibly also triggering penalties), for which the IRA owner would be solely responsible. However, the taxes and penalties can be avoided, if specific IRS-approved methods for transferring the IRA from one spouse to the other are used. For example, money can be transferred tax-free from one spouse's IRA to the other spouse's IRA in a trustee-to-trustee transfer, as long as the transfer is required by a divorce decree or separation agreement. Also, the transfer shouldn't take place before the divorce or separation is final, or it may be treated as a taxable distribution.

In Part 2 of this series I will talk about the tax consequences of divorce in the following areas:

  • Business interests
  • Estate planning considerations
  • Medical insurance
  • Tax records
  • Filing status
  • Adjusting income tax withholding
  • Notifying IRS of a new address or name change
  • Deducting legal fees

For all confidential questions on the above information, please feel free to contact us at (312) 629-0900.

Disclaimer: The information in this article is general in nature, and is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any action, you should consult a qualified professional advisor who has been provided with all pertinent facts relevant to your particular situation.

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