Poor planning regarding taxes can be costly for couples who are divorcing – especially without expert guidance. The negotiation process for a divorce settlement can be stressful enough, so it’s recommended to seek assistance from both an experienced divorce attorney and tax advisor. There are many details regarding a divorcing couple’s taxes that should be considered when finalizing a divorce. Each spouse should devote the time to become familiar with available tax resources, tips, and strategies so that each party can benefit in the best way possible.
Regardless of whether a couple is living together or not, the IRS continues to treat each party as a married individual if the couple is still legally married on the last day of the tax year. Neither party can file as unmarried or head of household in most scenarios unless a final divorce decree exists. While divorce or separation proceedings are pending, each party can choose from two filing options:
- Married person jointly with a spouse
- Married person separately
If married spouses choose to file separate tax returns, each spouse will report his or her income, exemptions, deductions, and credits meaning the responsibility for taxes and any interest or penalties due is that of each spouse individually.
Once a divorce has been finalized, each spouse has the opportunity to file as head of household if a dependent resides in their home and can be claimed. However, if the filer does not have physical custody of the dependent, this is an unlikely scenario. The spouse elected to file as head of household must pay more than half the home’s maintenance for a minimum of half the year being filed. Filing a tax return with the head of household status gives more favorable tax treatment than filing as single, and many divorcing spouses use this as a bargaining point when discussing settlement. In a situation in which two or more taxpayers may claim the same qualifying child as a dependent, the head of household is (a) the parent with the most overnights during the taxable year, or (b) if the child resides with both parents for the same amount of time, the parent with the highest adjusted gross income.
Consider Timing for Finalizing the Divorce
At times, waiting to finalize a divorce until after December 31st may be more worthwhile from a tax return perspective – especially if one spouse earns most of or all the income. In comparison, if both spouses are high earners, filing jointly could place each spouse in the highest tax bracket, whereas filing individually would not. It’s essential for divorcing couples to determine which scenario and timing would best benefit each spouse.
Who Gets Tax Credits?
It’s important for divorcing couples to know that dependents cannot be claimed by more than one person, meaning that understanding the rules the IRS utilizes to determine who can claim a dependent is vital. Usually, the parent granted the majority of overnight parenting time in a year is eligible for the child tax credit.
Spousal Maintenance and Child Support
Previously, if an ex-spouse is required to pay alimony or receive alimony, these payments are either deducted or reported on tax returns. Since 2018 when the Tax Cuts and Jobs Act (TCJA) was signed into law, spousal maintenance (also known as alimony payments) either paid or received and established under a final divorce decree, are no longer tax-deductible. Child support also doesn’t qualify as alimony, meaning these payments are not deductible or to be considered as taxable income.
Property transfers made during a divorce settlement are generally treated as non-taxable events for federal taxes and gift taxes. However, divorcing spouses may benefit from foregoing tax-free treatment for property transfers and, instead, structure the transaction as a true sale after the divorce is finalized
Divorcing couples are encouraged to discuss the allocation of tax carryovers when negotiating how marital and non-marital assets and liabilities will be divided. Many are unaware that tax carryovers are considered to have inherent value, like property. Therefore, spouses must consider the following tax carryovers when planning for filing yearly taxes.
- Capital losses
- Passive activity losses
- Net operating losses
- Charitable deductions
Retirement Asset Transfer
Transferring all or part of a qualified retirement plan cannot occur in a divorce settlement unless the court has issued a qualified domestic relations order (QDRO).
Any transfer must meet IRS regulations to be exempt from taxes or early withdrawal penalties.
Strategic Planning Will Alleviate Stress
Navigating the negotiation process for a divorce settlement can be challenging, but being strategic about planning can alleviate stress for both parties. It’s recommended to look at each asset both individually and as part of the bigger picture. If a divorcing couple is unsure of where to begin managing taxes during a divorce, seeking guidance from an experienced divorce attorney and tax advisor will help immensely. An outside, clear-headed perspective is often needed to create a realistic divorce settlement, so all potential benefits and consequences can be considered. Divorcing couples can avoid unnecessary tax consequences resulting from poor planning by devoting time to strategic tax planning.
This article contains general legal information and does not provide legal advice or tax planning advice. For legal advice, please contact M. Sue Wilson Law Offices directly.