Consider These 7 Important Tax Issues Before and After Divorce
“Nothing can be said to be certain in this world except death and taxes.” – Benjamin Franklin, 1789
We’ve all heard. Some of us have even said this. This famous saying has been repeated over and over over the centuries as a fatalistic observation that describes both the inevitable and the inevitable.
While the concept of death seems simple enough, with the passage of time it has been proved that taxes are becoming more and more complex. Taxes are a complex concept for many, even at a basic level. For anyone facing the prospect of divorce (which can feel like death), taxes are sure to be even more messy.
To help clarify some of the tax issues related to divorce, there are several points to consider both before and after finalizing your divorce.
Key tax considerations before finalizing your divorce:
1. Consider the tax implications of child support and alimony Child support and alimony can be the most contentious issue in any divorce. It can be challenging to strike the right balance between the ability to pay, the marital standard, the lifestyle needs of each spouse and, ultimately, the child custody schedule. Each has a huge impact on the bottom line.
Thanks to the Tax Cuts and Jobs Act of 2017, there was a major change in the tax law surrounding alimony. While child support is not tax deductible to the spouse who pays it and is not taxed by the receiving spouse, alimony payments are no longer tax deductible to the payer or to the recipient. is taxed as income. This new tax treatment greatly affects the amount of support ordered by courts, and what level of support is considered “reasonable” during arbitration or settlement. If you’ve been paying alimony for several years and your divorce was finalized before 2019, you’re a “grandfather” under the old rules—you’ll still be deducting payments from your tax return and your ex-spouse will pay that. but will continue to pay tax. paid as income.
If you included your alimony and child support together as “family support” in your agreement, it would be fully taxable to the recipient and deductible to the payer, as would alimony. The court order does not specify how much the family support order is for child or spouse 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. The divorces finalized before 2019 are grandfathered under the old rules.
2. Determine the best method of asset transfer – When couples are divorcing, property transfers between the parties generally do not result in any tax consequences for both parties. However, it makes sense to forgo the tax-free treatment that the law allows for the transfer of property to divorced spouses, and instead deliberately treat the transaction as a “true sale” to finalize the divorce. Forms a taxable event by being structured for more than one year after it is given. This may allow the spouse to purchase their former spouse’s share of the family residence for a benefit based on the increased cost on the property.
Example: Let’s say a couple in California bought a house for $1,000,000 and five years later they are divorcing the house, which is now worth $1,300,000. If they have a mortgage on the property for $700,000, the equity in the home would be about $600,000. At this point, the “tax impacting” home would conclude that if the wife were to keep the house and she sold it for $1,300,000, she would receive the first $250,000 of tax-free gains due to the capital gains exclusion. Primary Residence – She would have to pay federal and state taxes on the remaining $50,000 of gains, thus costing her approximately $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 move this asset to her side of the balance sheet, she will need to give another asset to her (soon) ex-spouse, $583,300.
But what if you structured this asset exchange as a purchase? The wife could “buy” the house from the community and both parties could benefit from the tax savings. If the community is to “sell” the wife, then both spouses’ capital gains exclusion will be in play. Not only would there be no tax on the “sale” of the home, but the wife would have a “new” cost basis of the house at $1,300,000—thus reducing her potential capital gains tax liability in the future.
Before tapping into the tax breaks suggested in this example, you should consult with your CPA and/or attorneys – resetting the tax base also means resetting the estate tax base. While the wife may save money on capital gains tax in later years, when she eventually sells the home, the annual property tax bill is likely to increase based on the new sale price.
3. Make Sure You Handle Retirement Accounts Carefully 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 an existing plan or roll the funds into an IRA. QDROs do not control the division and transfer of IRA assets. However, it’s very easy to transfer IRA dollars using a trustee-to-trustee (direct) transfer without any tax consequences — you simply open the IRA for the other spouse’s benefit and provide a copy of the divorce decree to the custodian. We do. maintains accounts). To be free of taxes and early withdrawal penalties, such transfers must be handled in accordance with IRS rules.
4. Know who is claiming the children as tax credit Only one spouse is able to claim the children as a tax credit after a divorce, so determine which spouse will receive the biggest benefit from that deduction and then look to profit sharing. Often it is the parents who spend the most time with the children who claim the children as dependents on their tax returns. If you instead allow the parent with the highest adjusted gross income (the one who makes the most money out of the deduction) to claim this tax credit, more money will be saved rather than spent on taxes.
Important tax considerations after you finalize your divorce:
1. One more word about claiming children as tax credit – The first spouse to file their tax return must claim the children, and the burden of proof actually falls on the second filer about whose right to make the claim. If you’re concerned that your ex may try to take a “dependent deduction” that you’re actually entitled to, be sure to file early so you don’t end up fighting for your right to that deduction with the IRS. Trying to resolve issues on your tax return through the IRS may be worse than working through your divorce with your ex on all issues.
2. Claim head of household if you have a child – if If you are considered unmarried on the last day of the year (whether divorced or legally separated), you can claim a higher standard deduction by claiming head of family. If you have custody of your children for more than half a year, you can claim head of family status….Even if your ex-spouse is already claiming the children as dependents on their tax return. Under the new tax law, the standard deduction for head of family is $18,000, compared to $12,000 for single filing status.
3. Know that you may still be audited – Just because your previous years’ tax returns were filed and already forgotten, remember that you and your ex can still be audited together on joint tax returns filed up to three years ago were done. Be prepared to cooperate and do your part to provide information or documents to support the data you entered with the IRS.
It is safe to say that even the founding fathers of our country could not have anticipated the complexities of our current tax system. Nevertheless, Benjamin Franklin was retrospective enough to recognize the certainty of taxes. With the awareness that taxes can and will undoubtedly play an important role in divorce, it is best to enlist a professional to help you plan for the best possible outcome.
The information contained herein is not personal. You should not assume that any discussion or information contained herein shall constitute or constitute a substitute for personal investment advice.