Top Tax Issues in a Divorce
Divorce is not a pleasant topic to discuss in any forum, but it is a fact of life in America with 40-50 percent or more of all marriages ending in divorce. Add taxes to the mix and the discourse becomes downright unsavory. Nonetheless, if you or someone you know is contemplating divorce, here are some of the most important tax issues to consider in negotiating a divorce or settlement agreement or in resolving a marital dispute.
1. Should the couple file a joint return or separate returns? This is usually the first question to be addressed, often in a hostile and emotionally charged environment. Ordinarily, a joint return produces a lower tax on the combined incomes of the husband and wife than filing separate returns. You should have an accountant run the numbers both ways to see what method produces the optimum result. Of course, a vindictive spouse may be unwilling to cooperate and jointly, often resulting in a higher tax to both parties. Keep in mind that the other spouse may want to demand compensation in the property settlement agreement for the higher taxes resulting from filing separately.
2. Innocent spouses should not be liable for problems created by the other spouse. Even if the couple files a joint return, an “innocent” spouse can elect to be protected from the improper or erroneous actions of the other spouse by filing Form 8857 and ensuring that certain requirements are met (including that the innocent spouse must not know or have any reason to know about the error or improper action resulting in a tax understatement). This will protect the innocent spouse from additional taxes, interest and penalties incurred by the offending spouse.
3. Who claims the dependents? Special support tests apply in the case of claiming the dependency exemptions for children of divorced parents. Generally, the custodial parent satisfies the support test and can claim the dependency exemption for the child if the child receives over one-half of his support during the calendar year from his parents who are divorced or legally separated under a decree of divorce or separate maintenance (or who are separated under a written separation agreement, or who live apart at all times during the last six months of the year), and the child is in the custody of one or both of his parents for more than one-half of the calendar year. Two basic exceptions apply to this rule: (1) the custodial parent agrees to allow the non-custodial parent to claim the exemption, and (2) a multi-party support agreement establishes who claims the exemption. In addition to dependency exemptions, the availability of tax credits and taxation of minor children should be factored into this analysis.
4. Property transfers incident to a divorce usually can be made without income tax consequences to either party, unless the property is transferred to a trust and the liability on the property exceeds the basis of the property transferred. Also, gain may be recognized on a property transfer to a third party by one spouse, where the transfer is made to satisfy a liability or obligation of a spouse. Gain also may be recognized where the property is not used in the same manner or for the same purpose as before the transfer. For example, an automobile used in an unincorporated business transferred to a non-owner spouse will cause depreciation recapture unless it is also used in the business by the recipient spouse. Despite the general rule of non-recognition of income, the IRS may nonetheless attempt to tax a transfer of accrued income (such as accrued interest, dividends or rent) to a spouse incident to a divorce, although not all courts agree with that position.
5. Disposition of Marital Home. Often the single most valuable marital asset (other than pension or retirement assets), the marital home is the subject of much negotiation in marital dispute resolution proceedings. Pursuant to the settlement agreement or divorce decree, one spouse commonly conveys his interest in the marital home to the other spouse or the spouses agree to sell the property to a third party. In the current down market or for other reasons (i.e., to allow the kids to remain in the marital home), the sale often is postponed until a later date. If one spouse transfers his interest in the marital home to the other spouse while they are still married or incident to a divorce, no gain is recognized on the transfer and the transfer is treated as a non-taxable gift. If the transfer is made to a former spouse not incident to a divorce or to a third party, it will be subject to tax. Other complications arising from the transfer of a marital home may include who is entitled to claim mortgage interest and tax deductions and who is permitted to claim the exclusion for the sale of a principal residence ($250,000 for single taxpayers and $500,000 for married filing jointly taxpayers), among other things.
6. Other tax issues to consider in divorce proceedings include the tax impact of distributing cash from a retirement plan or IRA versus designating a former spouse as a beneficiary on the plan or account, the deductibility of interest on promissory notes given in property settlements, who is entitled to receive tax refunds, treating payments as alimony (that are tax deductible to the payer and taxable to the payee, but precludes filing a joint return) versus child support (non-deductible and non-taxable), advantages of filing as “head of household,” the tax deductibility of life insurance premiums on policies for the benefit of the former spouse and/or children, tax treatment of stock redemptions in closely held companies, impact of qualified domestic relations orders relating to the assignment of accrued pension benefits, deductibility of attorneys’ fees, adjustments in after-tax asset values for taxes payable assuming an hypothetical liquidation of those assets, gift and estate tax issues, and other issues too complex to deal with in this column.
Bottom line: consult with your family law attorney and make a tax lawyer is involved in the process before signing on the dotted line.