April 30, 2019
Tax Issues Related to Divorce
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Article Highlights:
Family Court – All too often, family law courts make rulings that contradict federal tax law, causing confusion and inequities in divorce actions since family court rulings cannot trump federal tax law. A common occurrence is when a family court awards physical custody of a child to one parent and tells the other spouse he or she can claim the child as a dependent. However, federal tax law is very clear that the dependency goes to the custodial parent, regardless of what the family court had to say. However, if this is the arrangement that the divorcing couple actually wants, the custodial parent can provide the noncustodial parent with an IRS form relinquishing the dependency (more on this below).
Division of Property – When a couple divorces, their property is divvied up between them. This property settlement does not constitute a sale between the exes; therefore, no gain or loss is recognized. However, this presents a tax trap that both spouses should be aware of. The community basis transfers with the property, with the basis being the amount from which any gain or loss is determined when that property is later sold. This is best illustrated by example.
There is another issue to consider in our example. If the spouse who got the house lived in it for two of the five years preceding the sale, that spouse would be able to exclude $250,000 of home sale gain.
This is a very simplified example to illustrate how taxes can play into the division of property. In actual practice, other assets probably would be involved in equalizing the division of property.
Spousal Buyout Debt – Generally, only home-acquisition debt interest can be deducted on Schedule A. However, there is a special rule that secured debt incurred to buy out a former spouse’s interest in a home is acquisition debt. This rule is applied without regard to the rule that treats certain transfers of property between spouses incident to divorce as nontaxable events. Thus, the interest would continue to be deductible.
Filing Status – Your filing status is based on your marital status at the end of the year. If, on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or to each submit a return as married filing separately. There is an exception to this rule, however: if a couple has been separated for all of the last six months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child, then that spouse can use the more favorable head of household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must use the married filing separately status. If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.
Joint and Several Liability – When married taxpayers file jointly, they become jointly AND INDIVIDUALLY responsible for the tax and interest or penalty due on their returns. Joint filers remain “jointly and severally liable” even if a divorce decree states that a former spouse is responsible for any amounts due on previously filed joint returns. One spouse may be held responsible for all of the tax due, even if the other spouse earned all of the income. However, a spouse can request to be relieved of responsibility for tax, interest, and penalties on a joint return under special relief rules, including innocent spouse relief, separation of liability, and equitable relief. Please call the office to see if you qualify for one of these forms of relief. Although the tax may be lower by filing a joint return, there may be situations where it might be appropriate to elect to file separately.
Claiming the Children as Dependents – A common (and commonly misunderstood) issue for those who are divorced or separated and who have children is the choice regarding who claims a child for tax purposes. This can be a hotly disputed issue between parents; however, tax law includes very specific (albeit complicated) rules about who profits from child-related tax benefits. At issue are a number of benefits, including the child tax credit, child care credit, higher-education tuition credit, earned income tax credit, and, in some cases, filing status.
This is actually one of the most complicated areas of tax law. Taxpayers can make serious mistakes when getting ready to have their return prepared, especially if the parents are not communicating well. When parents cooperate with each other, they often can work out the best tax results overall, even though it may not be the best for them individually, and can then compensate for tax inequities in other ways.
When a court awards physical custody of a child to one parent, the tax law is very specific in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support the other parent provides. However, the custodial parent may release a child’s dependency to the noncustodial parent by completing the appropriate IRS form.
On the other hand, if a court awards joint physical custody of a child, only one of the parents can claim the child for tax purposes. If the parents cannot agree on who will claim the child, or if both actually claim the child, the IRS tiebreaker rules will apply. Per these rules, a child is treated as a dependent of the parent with whom the child resided for the greater number of nights during the tax year; if the child resides with both parents for the same amount of time, the parent with the higher adjusted gross income will claim the child as a dependent.
Head of Household Filing Status – An unmarried parent can claim the more favorable head of household (rather than single) filing status if that person (a) is the custodial parent and (b) pays more than one-half of the cost of maintaining the household that is the principal place of residence for the child (i.e., where the child lives for more than half of the year).
Higher Education Tuition Credit – If the child qualifies for either of two higher education tax credits (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit will go to whoever claims the child as a dependent. Credits are significant tax benefits because they reduce the tax bill dollar for dollar; deductions, on the other hand, reduce taxable income before the tax amount is calculated according to the individual’s tax bracket. For instance, the AOTC is a tax credit of up to $2,500, 40% of which is refundable. However, both education credits phase out for high-income taxpayers. For instance, the AOTC phases out at adjusted gross incomes between $80,000 and $90,000 for unmarried taxpayers and between $160,000 and $180,000 for married taxpayers. The phaseout ranges for the Lifetime Learning Credit are different and are inflation-adjusted annually – check with this office for the current amounts.
Child Care Credit – A nonrefundable tax credit is available to the custodial parent to offset the costs of child care, provided that the parent is gainfully employed or seeking employment. To qualify for this credit, the child must be under the age of 13 and be a dependent of the parent. However, there is a special rule for divorced or separated parents: when the custodial parent releases the child’s exemption to the noncustodial parent, the custodial parent still qualifies for the child care credit, and the noncustodial parent cannot claim that credit.
Child Tax Credit – A credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds one’s tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents and at $400,000 for married parents filing jointly. An older child may qualify the parent who claims the child’s dependency for a nonrefundable credit of up to $500, effective for years 2018 through 2025.
Earned Income Tax Credit – Low-income parents with earned income (either wages or self-employment income) may qualify for the EITC, which is based on their number of children (all those under age 19, plus full-time students under age 24), up to a maximum of three children. Releasing dependency of a child or children to the noncustodial parent does not disqualify the custodial parent from using the child/children to qualify for the EITC. In fact, the noncustodial parent is prohibited from claiming the EITC based on children whose dependency the custodial parent has released.
Alimony – The recent tax reform impacts the tax treatment of alimony.
Divorce Agreements Executed before the End of 2018 – For divorce agreements executed before the end of 2018, the recipient (payee) of the alimony must include that income for tax purposes. The payer in such cases is allowed to deduct the payments above the line (without itemizing deductions); this is technically referred to as an adjustment to gross income. (These rules don’t apply if the divorce decree specifies that the payments aren’t taxable/deductible.) The recipient who includes alimony income as taxable income can treat it as earned income for purposes of qualifying for an IRA contribution, thus allowing the recipient to contribute to an IRA even if he or she has no income from working. Because some of those who make alimony payments will claim that they paid more than they actually did, and because some recipients will report less alimony income than they actually received, the IRS requires that the paying spouse’s tax return include the recipient spouse’s Social Security number, so that the IRS can use a computer to match the amount received to the amount paid.
For Divorce Agreements Executed after 2018 – For divorce agreements that are executed after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income for the purposes of making an IRA contribution.
This revised treatment of alimony also applies to any divorce or separation instrument executed before the end of 2018 but modified after that date – but only if the modification expressly provides that the tax reform provisions apply.
Child Support – Not to be confused with alimony, child support is payments made by the non-custodial parent to the custodial parent for the care of their children. It is neither deductible by the payer nor income to the recipient. However, if the non-custodial parent directly pays medical expenses or medical insurance premiums, the non-custodial parent who itemizes their deductions can include those payments as a medical expense deduction.
Conflict of Interest – Rules of practice do not allow a tax practitioner to represent clients if there is a conflict of interest. If this office has been providing services to both parties in a pending divorce, there are some inherent conflicts of interest in providing advice or preparation services to both parties, so this office may be able to provide services to only one member of the former couple.
As you can see, some complex rules apply to divorce situations. Please consult this office if you have any tax questions related to a pending divorce action.
- Family Court
- Division of Property
- Spousal Buyout Debt
- Filing Status
- Joint and Several Liability
- Claiming the Children as Dependents
- Head of Household Filing Status
- Higher Education Tuition Credits
- Child Care Credit
- Child Tax Credit
- Earned Income Tax Credit
- Alimony
- Child Support
- Conflict of Interest
Family Court – All too often, family law courts make rulings that contradict federal tax law, causing confusion and inequities in divorce actions since family court rulings cannot trump federal tax law. A common occurrence is when a family court awards physical custody of a child to one parent and tells the other spouse he or she can claim the child as a dependent. However, federal tax law is very clear that the dependency goes to the custodial parent, regardless of what the family court had to say. However, if this is the arrangement that the divorcing couple actually wants, the custodial parent can provide the noncustodial parent with an IRS form relinquishing the dependency (more on this below).
Division of Property – When a couple divorces, their property is divvied up between them. This property settlement does not constitute a sale between the exes; therefore, no gain or loss is recognized. However, this presents a tax trap that both spouses should be aware of. The community basis transfers with the property, with the basis being the amount from which any gain or loss is determined when that property is later sold. This is best illustrated by example.
Example – The couple is working out their division of property, which consists of shares of stock currently worth $300,000 and a home worth $600,000, with a mortgage of $300,000 (net equity of $300,000). Thus, if one spouse took the stock worth $300,000 and the other spouse took the home with $300,000 of equity, it would seem like an even split. Unfortunately, this is the way some divisions of marital assets are determined, and they fail to take into consideration the tax aspects.
Suppose in our example that the $300,000 of stock had been purchased for $250,000. It would have a built-in gain of $50,000, and the spouse who got the stock would be responsible for tax on that $50,000 of gain when the stock is sold (assuming the market value when it is sold is at least $300,000). Also, suppose the home was originally purchased for $325,000. It would have built-in gain of $275,000, and the spouse who got the house would be responsible for the tax. Thus, even though the spouses split the equity in their property evenly, the spouse who got the home will assume a future tax liability on $225,000 more of built-in gain than the other spouse, and the sales costs of a home are considerably higher than those of stock, all of which should be taken into account when dividing up the assets.
Suppose in our example that the $300,000 of stock had been purchased for $250,000. It would have a built-in gain of $50,000, and the spouse who got the stock would be responsible for tax on that $50,000 of gain when the stock is sold (assuming the market value when it is sold is at least $300,000). Also, suppose the home was originally purchased for $325,000. It would have built-in gain of $275,000, and the spouse who got the house would be responsible for the tax. Thus, even though the spouses split the equity in their property evenly, the spouse who got the home will assume a future tax liability on $225,000 more of built-in gain than the other spouse, and the sales costs of a home are considerably higher than those of stock, all of which should be taken into account when dividing up the assets.
There is another issue to consider in our example. If the spouse who got the house lived in it for two of the five years preceding the sale, that spouse would be able to exclude $250,000 of home sale gain.
This is a very simplified example to illustrate how taxes can play into the division of property. In actual practice, other assets probably would be involved in equalizing the division of property.
Spousal Buyout Debt – Generally, only home-acquisition debt interest can be deducted on Schedule A. However, there is a special rule that secured debt incurred to buy out a former spouse’s interest in a home is acquisition debt. This rule is applied without regard to the rule that treats certain transfers of property between spouses incident to divorce as nontaxable events. Thus, the interest would continue to be deductible.
Filing Status – Your filing status is based on your marital status at the end of the year. If, on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or to each submit a return as married filing separately. There is an exception to this rule, however: if a couple has been separated for all of the last six months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child, then that spouse can use the more favorable head of household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must use the married filing separately status. If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.
Joint and Several Liability – When married taxpayers file jointly, they become jointly AND INDIVIDUALLY responsible for the tax and interest or penalty due on their returns. Joint filers remain “jointly and severally liable” even if a divorce decree states that a former spouse is responsible for any amounts due on previously filed joint returns. One spouse may be held responsible for all of the tax due, even if the other spouse earned all of the income. However, a spouse can request to be relieved of responsibility for tax, interest, and penalties on a joint return under special relief rules, including innocent spouse relief, separation of liability, and equitable relief. Please call the office to see if you qualify for one of these forms of relief. Although the tax may be lower by filing a joint return, there may be situations where it might be appropriate to elect to file separately.
Claiming the Children as Dependents – A common (and commonly misunderstood) issue for those who are divorced or separated and who have children is the choice regarding who claims a child for tax purposes. This can be a hotly disputed issue between parents; however, tax law includes very specific (albeit complicated) rules about who profits from child-related tax benefits. At issue are a number of benefits, including the child tax credit, child care credit, higher-education tuition credit, earned income tax credit, and, in some cases, filing status.
This is actually one of the most complicated areas of tax law. Taxpayers can make serious mistakes when getting ready to have their return prepared, especially if the parents are not communicating well. When parents cooperate with each other, they often can work out the best tax results overall, even though it may not be the best for them individually, and can then compensate for tax inequities in other ways.
When a court awards physical custody of a child to one parent, the tax law is very specific in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support the other parent provides. However, the custodial parent may release a child’s dependency to the noncustodial parent by completing the appropriate IRS form.
On the other hand, if a court awards joint physical custody of a child, only one of the parents can claim the child for tax purposes. If the parents cannot agree on who will claim the child, or if both actually claim the child, the IRS tiebreaker rules will apply. Per these rules, a child is treated as a dependent of the parent with whom the child resided for the greater number of nights during the tax year; if the child resides with both parents for the same amount of time, the parent with the higher adjusted gross income will claim the child as a dependent.
Head of Household Filing Status – An unmarried parent can claim the more favorable head of household (rather than single) filing status if that person (a) is the custodial parent and (b) pays more than one-half of the cost of maintaining the household that is the principal place of residence for the child (i.e., where the child lives for more than half of the year).
Higher Education Tuition Credit – If the child qualifies for either of two higher education tax credits (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit will go to whoever claims the child as a dependent. Credits are significant tax benefits because they reduce the tax bill dollar for dollar; deductions, on the other hand, reduce taxable income before the tax amount is calculated according to the individual’s tax bracket. For instance, the AOTC is a tax credit of up to $2,500, 40% of which is refundable. However, both education credits phase out for high-income taxpayers. For instance, the AOTC phases out at adjusted gross incomes between $80,000 and $90,000 for unmarried taxpayers and between $160,000 and $180,000 for married taxpayers. The phaseout ranges for the Lifetime Learning Credit are different and are inflation-adjusted annually – check with this office for the current amounts.
Child Care Credit – A nonrefundable tax credit is available to the custodial parent to offset the costs of child care, provided that the parent is gainfully employed or seeking employment. To qualify for this credit, the child must be under the age of 13 and be a dependent of the parent. However, there is a special rule for divorced or separated parents: when the custodial parent releases the child’s exemption to the noncustodial parent, the custodial parent still qualifies for the child care credit, and the noncustodial parent cannot claim that credit.
Child Tax Credit – A credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds one’s tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents and at $400,000 for married parents filing jointly. An older child may qualify the parent who claims the child’s dependency for a nonrefundable credit of up to $500, effective for years 2018 through 2025.
Earned Income Tax Credit – Low-income parents with earned income (either wages or self-employment income) may qualify for the EITC, which is based on their number of children (all those under age 19, plus full-time students under age 24), up to a maximum of three children. Releasing dependency of a child or children to the noncustodial parent does not disqualify the custodial parent from using the child/children to qualify for the EITC. In fact, the noncustodial parent is prohibited from claiming the EITC based on children whose dependency the custodial parent has released.
Alimony – The recent tax reform impacts the tax treatment of alimony.
Divorce Agreements Executed before the End of 2018 – For divorce agreements executed before the end of 2018, the recipient (payee) of the alimony must include that income for tax purposes. The payer in such cases is allowed to deduct the payments above the line (without itemizing deductions); this is technically referred to as an adjustment to gross income. (These rules don’t apply if the divorce decree specifies that the payments aren’t taxable/deductible.) The recipient who includes alimony income as taxable income can treat it as earned income for purposes of qualifying for an IRA contribution, thus allowing the recipient to contribute to an IRA even if he or she has no income from working. Because some of those who make alimony payments will claim that they paid more than they actually did, and because some recipients will report less alimony income than they actually received, the IRS requires that the paying spouse’s tax return include the recipient spouse’s Social Security number, so that the IRS can use a computer to match the amount received to the amount paid.
For Divorce Agreements Executed after 2018 – For divorce agreements that are executed after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income for the purposes of making an IRA contribution.
This revised treatment of alimony also applies to any divorce or separation instrument executed before the end of 2018 but modified after that date – but only if the modification expressly provides that the tax reform provisions apply.
Child Support – Not to be confused with alimony, child support is payments made by the non-custodial parent to the custodial parent for the care of their children. It is neither deductible by the payer nor income to the recipient. However, if the non-custodial parent directly pays medical expenses or medical insurance premiums, the non-custodial parent who itemizes their deductions can include those payments as a medical expense deduction.
Conflict of Interest – Rules of practice do not allow a tax practitioner to represent clients if there is a conflict of interest. If this office has been providing services to both parties in a pending divorce, there are some inherent conflicts of interest in providing advice or preparation services to both parties, so this office may be able to provide services to only one member of the former couple.
As you can see, some complex rules apply to divorce situations. Please consult this office if you have any tax questions related to a pending divorce action.
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