Whether you oversaw family finances while married or this is your first time looking at taxes, this guide will help you. Divorce is complicated, and taxes are especially complicated. You need to pay special attention to taxes in the years you are going through divorce and the year you are officially single. Making a mistake with your taxes during the divorce process can affect you for decades and perhaps cost tens of thousands of dollars or more. This guide will help you easily navigate the complex elements of taxes during divorce.
In Your Easy 2017 Guide to Taxes in Divorce, you will learn the most important tax topics to consider during divorce. While taxes are never a fun subject, they are necessary, and you will receive reliable information that you need. In fact, the Internal Revenue Service (IRS) has various “publications” that provide detailed information on tax issues. IRS Publication 504, Divorced or Separated Individuals is a 28-page booklet about tax issues in divorce. If you love studying and reading about taxes, you can check it out and skip this guide, but I have read Publication 504 for you. I’m only going to give you the best parts in an easy-to-understand format.
We will cover four major topics:
1) What filing status do you choose when you are getting divorced?
2) Paying or Receiving Spousal Support? Avoid these traps.
3) Child support is easy from a tax perspective.
4) Five important tax tips when negotiating your divorce settlement.
A quick disclaimer: I am not an accountant or an attorney. I’m a Certified Divorce Financial Analyst. I cannot provide tax or legal advice, and you need to consult experts about your specific case. Taxes and laws vary by state, and everyone’s situation is different. While this guide will help you understand the major issues, be sure to consult your own experts.
When you think about personal taxes, we are going to focus on Form 1040, which is the U.S. Individual Income Tax Return. Give it a quick review. It’s short and quite simple . . . until you start filling out each line of the form. We’re going to cover a few high-level issues related to Form 1040 that are particularly relevant as you’re getting divorced starting with “Filing Status.”
Form 1040 provides five options:
• Married filing jointly
• Married filing separately
• Head of household
• Qualifying widower
Except for “qualifying widower,” which is a special situation that is not related to divorce, we will go through each of these options in more depth, as your Filing Status helps determine how much tax you must pay on your income. This is a very important section that you need to understand. Even though it’s just a quick checkbox, what you select affects how much and what tax deductions, exemptions, and credits you will receive—potentially for many years to come. (For our purposes, you don’t need to know the difference between deductions, exemptions, and credits, but you should know that the more you have, the less tax you will pay.)
Your Filing Status is mostly determined on December 31 of the tax year. If you were officially divorced in March or November 2016, meaning that a judge signed your final divorce decree, it means you were divorced for the whole year. Legal separation counts as divorce for our purposes as well but only if your state recognizes it.
If on December 31 of the tax year you are:
Married Filing Jointly
Married Filing Separately
Head of Household
Divorced or Legally Separated
Head of Household
For most people going through divorce, this is the best option if you want to minimize your annual tax bill. When you file your taxes as married filing jointly, both you and your spouse will file a joint tax return. It will include each of your incomes, exemptions, deductions, and credits, and you will both sign the same return.
While Married Filing Jointly usually provides the most tax benefits, the major downside is that you are legally liable for what appears on the tax return. If you owe taxes, even if you did not earn the income, you are equally responsible for those taxes with your spouse. If tax penalties or other issues are involved, you are liable because you signed a joint return. You should be careful in the event it is later discovered there was an issue with the tax return you signed. This applies even after the divorce is over and even if the divorce decree states otherwise. If it’s later discovered there was an issue with a joint tax return, you are liable since your name is on the document.
It is not all bad news, however, because if you do find yourself in a situation where you are unexpectedly liable for something on a joint tax return, you have some options if you look for information from the IRS regarding innocent spouse relief, separation of liability, or equitable relief.
Conclusion: For Married Filing Jointly, even though you will usually end up paying less in taxes, if you suspect tax issues or potential fraud may be involved, you may want to consider Married Filing Separately.
When you are still legally married, you and your spouse can file separate tax returns by selecting Married Filing Separately. If you select this option, from a tax perspective, you are only considering your individual income, exemptions, deductions, and credits. This option is usually more expensive from a tax perspective because many tax benefits are related to marriage. The IRS presents a set of warnings if you choose Married Filing Separately:
1. Your tax rate generally is higher than it would be on a joint return.
2. Your exemption amount for figuring the alternative minimum tax is half of that allowed on a joint return.
3. You can’t take the credit for child and dependent care expenses in most cases, and the amount you can exclude from income under an employer's dependent care assistance program is limited to $2,500 (instead of $5,000 on a joint return). If you are legally separated or living apart from your spouse, you may be able to file a separate return and still take the credit. See Pub. 503 for more information.
4. You can’t take the earned income credit.
5. You can’t take the exclusion or credit for adoption expenses in most cases.
6. You can’t take the credit for higher education expenses (American opportunity and lifetime learning credits), the deduction for student loan interest, or the tuition and fees deduction.
7. You can’t exclude the interest from qualified savings bonds that you used for higher education expenses.
8. If you lived with your spouse at any time during the tax year:
a. You can’t claim the credit for the elderly or the disabled, and
b. You will have to include in income a higher percentage (up to 85%) of any social security or equivalent railroad retirement benefits you received.
9. The following credits and deductions are reduced at income levels that are half those for a joint return.
a. The child tax credit.
b. The retirement savings contributions credit.
c. The deduction for personal exemptions.
d. Itemized deductions.
10. Your capital loss deduction limit is $1,500 (instead of $3,000 on a joint return).
11. If your spouse itemizes deductions, you can’t claim the standard deduction. If you can claim the standard deduction, your basic standard deduction is half the amount allowed on a joint return.”
As you can see, you will probably face a higher tax bill when you are Married Filing Separately than Married Filing Jointly. So why would you do it? It all boils down to liability. If your spouse does something suspicious, such as incorrectly filing taxes, hiding money, or is involved in illegal activities, and you sign a joint tax return, it means you are liable for many of those consequences. So even though you may face a higher tax bill, a separate return means that you are only liable for what you put on your own tax return, not what your spouse does.
Filing as Head of Household is an option whether you are married or already divorced and have children. If you are still legally married, however, there is a special set of requirements you must meet here.
If you have children, filing as Head of Household will lead to the lowest tax bill as opposed to filing as Single. The main requirements for qualifying for Head of Household are 1) you have a child who lives with you more than half the year and 2) you need to have paid more than half the costs of keeping up the home. A full set of rules is provided in Publication 504.
The benefits of claiming Head of Household status is that you have higher deductions, more credits, and an overall lower tax rate than if you file your taxes as Single. In general, but not always, Head of Household has more benefits than Married Filing Separately.
If you have more than one child, it is possible that both you and your (ex-) spouse can file as Head of Household. You both must meet certain requirements, but it is a possibility.
If you don’t have any children or if you cannot claim Head of Household status, you must file as Single, which means you will pay the highest tax rates. As the saying goes, “It is what it is.”
Spousal support, also called alimony or maintenance, is a payment made to a former spouse as part of a divorce or separation agreement. Spousal support is taxable for the recipient and tax deductible for the payer. If you receive spousal support, that money counts as income to you, and you must pay taxes on it. If you are paying spousal support, those payments are deductible from your income.
Only payments specifically made as part of the divorce or separation agreement are considered alimony for tax purposes, meaning that voluntary or bonus payments are not included. Temporary spousal support is regarded the same as permanent spousal support from a tax perspective. Certain types of payments do not qualify as spousal support:
• Child support
• Noncash payments
• Money for keeping up the payer’s property, such as repairs on a home
• Use of the payer’s property, for example, lending a home to a former spouse
You can, however, make payments to a third party on behalf of an ex-spouse and qualify for spousal support. For example, payments for such things as medical expenses, taxes, and tuition can still qualify as spousal support. Payments must be made in cash, so transferring property or providing a service for payment does not count as spousal support in the eyes of the IRS.
Advanced Tip: Since spousal support is taxable income for the recipient, you can use income from spousal support payments to contribute to retirement accounts.
Child support has different tax rules than spousal support. Child support is not tax deductible for the payer and is not taxable for the recipient. Child support comes from after-tax money. What does that mean in practice? If you are paying child support, it is much more expensive than receiving child support because you do not receive any tax benefits for paying it. If you are receiving child support, it’s a big benefit for you because that money is not taxed.
You need to have your own CPA when you are getting divorced and the year immediately following your divorce. It will cost you a little more money than simply using your spouse’s CPA or software, such as HR Block or TurboTax, but the many complex pitfalls that may occur during divorce can cost you dearly if you’re not careful. What if your spouse makes a mistake in preparing the tax returns? What if your spouse commits fraud? Anything can happen during divorce, and you need your own CPA to help you avoid major issues.
Taxes are complicated, and having a CPA to help you immediately following your divorce can ensure that you save money in tax payments. You need to be aware of several tax breaks and changes during divorce, and it’s better to complete things correctly than to find out years down the line that you have been paying too much!
You should know that most property transferred “incident to divorce” is tax free. Property includes such things as homes, cars, and investment accounts. If transferred as part of the divorce, there is no tax benefit or disadvantage to receiving the assets. For any assets you receive, you need to know the “tax basis” or “cost basis.” This amount is usually the purchase price of the property (though it can get complicated when discussing such assets as homes). If you sell any asset later, the cost basis will be relevant for calculating capital gains. Also note that there is no step up or change in cost basis for assets transferred as part of divorce.
Advanced Tip: Consider getting spousal support paid in a lump sum, as you can avoid counting that money as future income if the money is transferred as part of the property settlement.
But don’t ignore the tax consequences.
If you plan on selling all or part of any property you receive during divorce, you need to understand the tax consequences. Some assets (e.g., stock that has increased in value, retirement accounts, homes) may have very substantial tax consequences if you need the funds. Imagine negotiating for an investment account in divorce worth $1,000, and when you sell it for money you find out after taxes that it’s worth only $500? It’s a common situation that many people forget about during divorce. Consider getting help from your CPA or Certified Divorce Financial Analyst (CDFA) to help you analyze the tax impact of selling your property.
If you plan to sell your home in the near future, you can take advantage of substantial tax benefits by selling the house while still married. You can exclude the first $500,000 of capital gains taxes (the tax you pay when property increases in value) on your main residence when you are still married. If you wait until you are divorced, that exclusion reduces to $250,000, so you could end up paying much more in taxes than necessary.
Are you and your soon to be ex-spouse expecting a tax refund? Don’t forget to negotiate who keeps the refund. Don’t let your spouse steal it from you, and you should not steal it from her either.
If you have children, you should consider negotiating for various child-related tax benefits, such as the Standard Deduction, Dependency Exemption, Child Credit, and American Opportunity Credit. If you have primary custody of the children, you will have an easier time receiving child-related tax benefits. You can negotiate as part of your settlement to keep many child-related tax benefits even if you don’t have primary custody. Depending upon your circumstances, this can be a valuable benefit that most people forget about.
Taxes are usually one of the last items on people’s lists when it comes to divorce, even though it requires just as much time and attention as every other element in the divorce process. Failure to properly consider your options with taxes can lead to tens of thousands of dollars in expenses and years of regret. Make sure you make the right tax decisions for your situation to help protect your financial interests and future.
For further reading, please consider the following IRS Publications available on https://www.irs.gov.
17—Your Federal Income Tax
504—Divorced or Separated Individuals
523—Selling Your Home
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Shawn Leamon, MBA and Certified Divorce Financial Analyst, is the host of the Divorce and Your Money Show, the #1 show on iTunes that discusses personal finance issues in divorce. He is also author of Divorce and Your Money: The No-Nonsense Guide, available on Amazon. Learn more at www.divorceandyourmoney.com.
Disclaimer: Divorce and Your Money and its affiliates do not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.