Why are Tax Issues So Important in Divorce?
Divorce or separation can be stressful and can turn someone’s world upside down. However, when it happens divorce settlements often result and marital assets don’t always get distributed the way you expect. We explore situations in which divorce affects income taxes and your tax liability including property transfers and noncash property settlements.
Do You Have to Pay Tax on Alimony?
Alimony is a court-ordered financial settlement that someone pays to their former spouse. Payments resulting from a separation agreement is considered alimony if all the following are true:
· The payments are in cash (checks are considered cash)
· The payments are not for child support
· No obligation exists after the death of the receiving spouse
· The individuals do not live in the same household
· No joint tax return is filed
Historically, men have been the breadwinners in relationships and were the ones to pay alimony. However, as women become more successful and financially independent in today’s society, they too have been on the paying side of divorce agreements. Even celebrities feel the pinch. It has been reported that Grammy Award-winning singer Mary J. Blige was ordered to pay her ex-husband $30,000 per month in alimony.
The Tax Cuts and Jobs Act disallowed tax deductions for alimony payments after 2018. It also made alimony tax-free to the recipient.
Alimony payments are usually for a fixed period of time but they could be indefinite or up until the receiving spouse remarries. The payments are typically paid directly to the receiving spouse but in certain cases payments can be made directly to a third-party if they do not benefit the paying spouse.
Community Property and Divorce Settlements
In community property states half of the income earned by one spouse is typically considered earned by the other spouse. While laws vary by state, in general, assets earned while married are considered community property. Assets that were owned by each individual prior to the marriage is considered separate property. There are 9 community property states. They include:
· New Mexico
A couple is considered married if they are married as of the last day of the year. Upon divorce their income is no longer community property and should be reported by the person who earned it.
Do You Pay Tax on Child Support?
In addition to a loving home, courts also understand that children have financial needs. Therefore, it is no surprise that divorce settlements often come with stipulations that an ex-spouse make child support payments.
Where things can sometimes get confusing is when a divorce settlement specifies that the former spouse pay a certain amount which only partially includes child support. Why does this matter? It is important because child support is not taxable by the recipient. Additionally, child support payments are not deductible by the paying parent.
It is important to determine what amounts are truly “alimony” as specified in divorce settlements as they may differ from what is allowed for tax purposes.
Tax Filing Status After Divorce
If children are involved in the breakup your filing status may be affected. A legally married couple may file married filing jointly or married filing separately. If one spouse wants to file married filing separately then both must file separate tax returns.
Upon divorce the individuals can file as single or, if a parent qualifies, as head of household. Someone who is legally separated by the end of the year is considered unmarried by the Internal Revenue Service (IRS).
The head of household filing status is more desirable because the standard deduction that the IRS allows is greater than for someone filing as single. For 2024 taxpayers who file single or married filing separately get a standard deduction of $14,600 but those filing as head of household are allowed a standard deduction of $21,900.
To qualify to file as head of household a person needs to:
· Have a qualifying person living with them for more than half the year
· Provide more than 50% of the qualifying person’s support for the year
· Not be married or “considered unmarried” as of December 31
A qualifying person is generally a child by blood, marriage or adoption or qualifying relative. A parent may be a qualifying person even if they do not live with the person claiming head of household filing status. Your filing status has tax implications and you should plan ahead.
NOTE: A married person can be “considered unmarried” if he or she does not live with their spouse for the last 6 months of the tax year.
Property Settlements in Divorce
In some divorces the ex-spouse is granted property in the final settlement. The federal tax code notes that if property is transferred between former spouses incident to a divorce then no tax is due by either person. The transfer of property should take place as part of the divorce settlement or within 1 year from the divorce to meet these guidelines. The exception to this rule is when the property is transferred to a nonresident alien spouse.
The ex-spouse receiving the property should be aware of, and track, the basis of the property received. Basis, which in simple terms is the cost plus any improvements made on the property, would be the same to the divorced recipient as it is to person who had to give up the property. This is particularly important if the property has a significant increase in value and the receiving spouse’s intent is to sell the it after the divorce is finalized.
EXAMPLE: Paula and Chris have been going through rocky times in their marriage and decide to divorce. Chris owns a house that is worth $300,000 and has a basis of $100,000. As part of the divorce settlement Paula receives the house which will also have a basis to her of $100,000. Neither Chris or Paula will recognize gain or loss on this transfer.
A married couple on the brink of divorce should consider taking advantage of the Section 121 exclusion. Named after the section of the IRS code, the Section 121 exclusion allows a couple who files a joint tax return to exclude up to $500,000 of gain from the sale of the primary residence. To qualify you must own the home and use it as your primary residence for 2 of the prior 5 years. A single person is allowed to exclude only up to $250,000 in gain.
Who Owes Back Taxes After Divorce?
When a married couple files a joint return, they are both jointly and individually liable for any tax due. This means that if you filed married filing jointly before divorce the IRS or State could still look to collect taxes owed even after the divorce. This is true even if a divorce decree says that one former spouse is responsible for the taxes!
You may want to get rid of everything connected with your former spouse but the joint tax return that was filed shouldn’t be one of them. It is especially important as tax agencies are notorious for sending delinquency notices years after the tax returns have been filed.
If your former spouse failed to report income or tax was understated there may be a solution. The IRS allows a taxpayer to file an innocent spouse claim to avoid their former spouse’s unpaid tax. However, to qualify you must not have known and had no reason to know that the underreporting existed.
As an alternative to an innocent spouse claim a taxpayer may seek a refund or waiver of unpaid tax and penalties through equitable relief. This option is a request to the IRS to only hold you responsible, based on your share of the joint income, for the equitable distribution of tax. The IRS will factor in whether the tax burden will cause undue hardship if not granted.
IRAs and 401(k)s in Divorce Settlements
It is common for both spouses to have individual retirement accounts such as a 401(k) or IRA. If you plan on getting a divorce you can’t just pull money out of your spouse’s account even if you believe you are entitled to it. You would need a court order, such as a Qualified Domestic Relations Order (QDRO) to legally grant you access to those funds. Without such legal documentation a distribution could result in additional taxable income and possibly an early withdrawal penalty.
Certain divorce settlements may call for one spouse to give some of their retirement plan benefits to a spouse. The distributed retirement plan funds would be taxable to the receiving spouse unless he or she rolls the money into another retirement plan such as an IRA. On the other hand, a judgement in which someone receives only an interest in a former spouse’s IRA is not considered a taxable transaction.
Updating Your Will or Power of Attorney
If you have a will or power of attorney it is a good time to update it. These documents sometimes are forgotten in the chaos of divorce but failing to make changes can result in assets going to unintended beneficiaries.
Get Professional Help With Divorce and Taxes
The divorce process can be challenging and getting good tax advice early is always beneficial. Work with a tax professional, financial planner or divorce attorney so you can avoid negative tax consequences and unnecessary surprises.
Get Help Tax serves clients in all 50 states.