15 Tax Issues of Divorce

15 Tax Issues of Divorce

Divorces have become a normal occurrence and taxes are usually a part of any final settlement. Here are some tax issues to be aware of.

1. Child support is not deductible by the payer, nor taxable by the recipient.
2. Alimony payments are deductible by the payer and taxable to the recipient. Alimony payments must be “substantially equal” and paid over more than three years (barring a marriage or death) and must be made pursuant to a written order or agreement and terminate upon the death of the payer or payee, or when the payee remarries; the couple cannot file a joint tax return and cannot live in same household. Instead of direct payments, payments can be made on behalf of the former spouse, such as for medical and life insurance premiums or mortgage payments (for loans taken out in the name of the payee spouse) and real estate taxes.
3. Alimony pendente lite is temporary alimony while the divorce action is in progress and qualifies as alimony since it is paid pursuant to a court order or decree. Without that decree payments made to support the spouse are not deductible by the payer, or taxable by the recipient.
4. Alimony trusts can be established under IRC Section 682. While trust assets may revert to the grantor, alimony trusts are treated as non-grantor trusts for tax purposes. The spouse receiving the income is taxed on distributions, with undistributed income taxed to the grantor spouse. Exception: Receiving spouses are not taxed on any trust income designated as child-support. Instead, that income is taxed by the payer spouse. Additionally,properly structured alimony trusts that own life insurance policies will pass the proceeds estate tax-free. Note that life insurance owned by the insured will be includible in the insured’s estate even though the proceeds are paid to the former spouse.
5. Property transfers are not deductible to the spouse transferring the property (or the spouse receiving them) and can be made in a lump sum or in periodic payments. Often, the only difference between alimony and property-settlement payments is the label the couple attaches to the payments in the separation agreement. Such settlements are not subject to gift tax.
6. Consider eventual capital gains taxes when property settlements are allocated. While income taxes don’t apply to property settlements, capital gains tax is owed when an asset received in settlement of divorce is sold on the difference between the sales price and the asset’s tax cost. The person receiving property would want assets with a high tax cost while the person transferring property wants to give assets with a low tax cost. Example: In their settlement, one spouse receives $100,000 cash and the other spouse receives shares of stock worth $100,000. The tax cost of the shares is $20,000. When the stock is sold, capital gains tax will be owed on the $80,000 difference between the sales price and its tax cost, reducing the value of the settlement.
7. IRAs and pensions can be divided tax-free if there is a special court issued Qualified Domestic Relations Order (“QDRO”). Note that any eventual distributions from the retirement accounts will be taxed to the recipient.
8. Tax-free “remarriage bonuses” to an ex-spouse can be included in property-settlement agreements. This would be done where high alimony payments stop upon the marriage.
9. Couples that are legally married on the last day of the year must file a joint tax return for that year, or separate returns as married people filing separately. But, someone who has lived apart from his/her spouse for the last six months of a year and has a dependent child can use head of household status which is better than married filing separate rates.
10. A divorced parent with custody of the couple’s children is automatically entitled to claim dependency exemptions. Noncustodial parents can claim dependency exemptions for their children if the custodial parent agrees to transfer the exemptions either in the divorce agreement or afterwards on a permanent or year-by-year basis using IRS Firm 8332.
11. Medical insurance and expense payments on behalf of children can be deducted even if the payer cannot claim dependency exemptions for them.
12. Legal fees related to divorce can be deducted as a miscellaneous itemized deduction (subject to Tax Code limitations) to the extent they are allocated to tax advice about paying alimony. Ask the attorney to state the amount separately on their bill.
13. When a couple sells their primary residence as part of a divorce settlement, profits from the sale can be sheltered by the full $500,000 income exclusion even if one spouse moved out of the house before the property was sold. The divorce or separation agreement must cover this. For this purpose the spouse who owns the house but doesn’t occupy it is treated as if they occupied the house during the time the former spouse lives there.
14. There are a number of ways to treat joint estimated tax payments including prior year refunds that were applied to the current year. It is best if both parties agree on the allocation and the IRS will accept that allocation. If they don’t agree, there is a procedure to allocate the payments which can be found in IRS publication 504.
15. Carryovers such as for capital losses and net operating losses will need to be allocated. This should be discussed with a tax advisor, as should everything else in here.

The above is meant as a guide. There are many other tax issues. Those involved in a marital separation or divorce should seek competent advice to minimize the tax consequences of their divorce settlement.