Divorce proceedings pose numerous tax percussions which offer challenging planning considerations for separated and divorced taxpayers, including the change in filing status and the treatment of certain income and deductions related to children, alimony, property transfers and the marital home. Thorough consideration of the tax treatment is essential for negotiating equitable divorce settlements.
Married taxpayers have the option of filing a joint return or each filing their own separate returns. Generally, filing jointly produces a lower aggregate tax, while filing separately may be advantageous to one spouse. Joint filers are jointly and severally liable for all income tax, related penalties and interest, including later determined deficiencies, subject to innocent spouse relief.
Only individuals who are married at the close of the tax year may file a joint return. Spouses legally separated under a decree of divorce or separate maintenance are not considered married for tax purposes. If a taxpayer is unmarried, he or she must file as a single taxpayer unless he or she meets the requirements for filing as head of household, which has lower marginal rates.
Tax Benefits of Children:
Generally, the child of a divorced or separated parent qualifies for the dependency exemption of the parent that he or she resided with for the longer period of time during the tax year (known as the custodial parent).
Parents may not split the tax benefits arising from the dependency exemption (such as the child tax credit and dependent care credit), although, in the case of more than one child in the family, each parent may claim a different child. In contrast, where a student is a claimed a dependent, qualified tuition and related expenses paid by the student are treated as paid by the taxpayer, even if paid by a third party.
Alimony & Child Support:
Alimony is a form of support which is taxable to the payee spouse and equally deductible to the paying spouse, making alimony a useful tool in shifting income to the spouse in the lower tax bracket. Additionally, alimony payments can be made to third parties for the benefit of the payee spouse, enabling support agreements to be fully deductible, where they may otherwise be limited.
In contrast, payments representing child support are neither includible in the income of the payee nor deductible by the paying spouse.
Property & Stock Transfers:
Generally, no gain or loss is recognized on a transfer of property from an individual to a spouse or former spouse if the transfer is incident to a divorce. Non-recognition applies even where the parties are acting at arm’s length and the transferee spouse pays full consideration for the property.
For retirement accounts, a spouse or former spouse of an employee may receive a tax-free rollover distribution from that employer’s qualified retirement plan as part of a court-approved property settlement.
The Marital Home:
The non-recognition rule applies to a spouse’s transfer of the martial home incident to divorce. If the home is later sold to a third party, gain up to $250,000 can be excluded from gross income, provided the spouse has owned and used the home as his or her principal residence for periods aggregating two of the five years immediately prior to the sale.
The tax savings in a proposed settlement which obligates one party to pay debt and taxes on the former marital home (providing for significant tax deductions to the paying spouse) should be used as leverage in negotiations.