6 Tax Considerations for Divorcing Couples
While you may want to finalize your divorce as quickly as possible so you can move on with your life, there are important tax considerations to make during the divorce process. The transfer of property and assets, the sale or transfer of your home, and your filing status could all majorly affect your tax bill. If you overlook the possible tax implications of these payments and transfers, it could be costly for years to come.
We are going to go over 6 key tax issues to be aware of if you’re going through a divorce. Especially with money and finances, one misstep or mistake can cost you a lot. Finding a lawyer who can see the big picture, as well as a financial professional who has worked with people in similar situations, is going to pay off in the long run.
Alimony is also known as spousal support. It is money that one ex-spouse pays to the other, often in place of income. Under the Tax Cuts and Jobs Act of 2017, divorces finalized after December 31, 2018 have different tax consequences for alimony than divorces finalized prior to that date. After 2018, alimony is no longer taxable income to the recipient nor is it tax deductible by the ex-spouse who is paying it. For information regarding alimony tax issues, review IRS Publication 504.
2. Child support
Child support is money one ex-spouse pays to the other for the benefit of dependent children to cover regular living expenses such as food and clothing. It has no tax consequences. It is not a tax-deductible expense or income.
3. Assets and property
There are no tax consequences for the transfer from one spouse to the other of mutual funds, stocks, bonds, or other securities held outside of retirement plans. In fact, most asset and property transfers made as part of the divorce process are not taxable events for federal income taxes or gift taxes. This means there are no gains, losses, or taxes associated with them.
The transfers can be made up to one-year after the divorce is finalized. They can also be made up to six years after the divorce is final if it is a condition of the divorce agreement or order. You have even longer to make these transfers if there are legal or business impediments to the transfer so long as the transfer occurs as soon as the impediment is removed. There is no change to the cost-basis either as the property or asset is deemed owned by both spouses during the marriage so that the holding period and cost-basis transfers to the ex-spouse who receives the property.
There are, however, exceptions. For example, the transfer of U.S. Savings bonds is a taxable event. In addition, if one spouse is not a U.S. citizen and lives abroad, transfers of property could be subject to certain taxes imposed on foreign nationals or could be taxed as a gift. IRS Publication 504 provides additional information about taxes related to property transfers.
4. The marital home (principal residence)
Your martial home is subject to capital gains taxes when you sell it but there is a limited capital gain exclusion provided by the IRS. If you are divorcing and selling your house, meeting with and proactively planning can help you maximize your tax savings from the principal residence gain exclusion.
Under current tax law, an unmarried individual can sell a principal residence and exclude up to $250,000 of gain from their taxable income. A married joint-filing couple can exclude up to $500,000. However, homeowners must pass the two tests to qualify.
- Ownership test. You generally must have owned the property for at least two years during the five-year period ending on the sale date.
- Use test. You generally must have used the property as your principal residence for at least two years during the same five-year period.
To claim the larger $500,000 joint-filer gain exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
If you don’t pass both tests, your tax advisor should look at a partial gain exclusion, assuming you sell your primary home for specified reasons that are deemed to be beyond your control. Examples include a job change or health issues.
Some couples decide to sell their principal residence while they’re in the process of getting divorced. If you’re still legally married on December 31 of the year the house is sold and closes, you’re considered married for the entire year for federal income tax purposes. In this scenario, you can shelter up to $500,000 of home sale profit in two different ways.
- You and your soon-to-be-ex can file a joint tax return for the year of the sale and claim the $500,000 joint-return gain exclusion.
- You and your soon-to-be-ex can file separate returns. Assuming the home is owned jointly or as community property, you can both exclude up to $250,000 of your share of the gain. To qualify for separate $250,000 gain exclusions, each spouse must pass the ownership and use tests.
Alternatively, if you’re divorced at the end of the year in which you sell your principal residence, you’re considered divorced for that entire year for federal income tax purposes. So, you can’t file a joint return with your ex-spouse for the year of the sale or any later year.
If both spouses retain partial ownership of the home in the divorce settlement, what happens when you sell the home? In that year, both spouses can exclude up to $250,000 of your respective shares of the gain if you both pass the ownership and use tests.
Alternatively, if only one spouse winds up with sole ownership after the divorce, that person’s maximum gain exclusion is $250,000, because he or she is now single. However, if that person remarries and lives in the home with the new spouse for at least two years before selling, the larger $500,000 joint-filer exclusion becomes available.
It gets tricky in situations where the ex-spouse owns all or part of the marital residence but no longer lives in the home. If that non-resident spouse hasn’t lived there for two of the past five years at the time of sale (after divorce), then he or she can’t pass the use test—which would make their gain fully taxable. There is a possible solution for this though. A tax strategist and a family lawyer can help you craft language to receive “credit” for your ex-spouse’s continued use of the property as their principal residence as a condition of the divorce agreement so long as the occupation is until the kids reach a certain age or for a specified number of years AND once that prescribed time frame expires, the home can either be put up for sale with the proceeds split according to the divorce agreement, or one ex can buy out the other’s share for current market value.
Carefully worded divorce agreements are critical to qualify for the home sale gain exclusion in certain situations. A keen understanding of the federal income tax rules and proper planning before the papers are finalized can help soon-to-be-ex-spouses avoid costly mistakes.
5. Retirement accounts
In order to transfer all or part of a qualified retirement account or pension plan as part of a divorce settlement, a court must issue a qualified domestic relations order (QDRO). The retirement plan benefits received as part of a divorce settlement or decree are treated by the IRS as if the recipient received the benefits under their own retirement plan. The ex-spouse can roll over their share to their own retirement plan. This roll-over is tax free, like other roll-overs. IRS Publication 575 gives detailed information about retirement account taxation.
For IRAs, tax advisers tell us that the parties must wait and rollover the funds at the time of divorce for the transfer to be tax-free under Federal Law as the law requires the transfer be pursuant to a “decree of divorce or separate maintenance or a written instrument to such a decree.” North Carolina does not have decrees of separate maintenance, and a Private Letter Ruling from the 90’s told one set of taxpayers that a separation agreement was not incident to a divorce decree and the IRA transfer was taxable. While Private Letter Rulings from the IRS are not binding on the IRS or future taxpayers, many conservative tax advisors take the position that you are safest to wait until divorce to transfer IRA money in North Carolina.
6. Filing status
Your status for tax filing is determined on December 31 of the tax filing year. If your divorce is finalized prior to that date, you will file as single, or as head of household if you have a dependent who lives mostly with you. Only you or your ex-spouse – not both of you – can file as head of household for the same dependent. You want to include in your divorce settlement agreement who has the right to claim any dependents, usually your children, on your tax returns. If your divorce was not finalized on December 31, you want to consider whether to file jointly or as married filing separately. Consider that filing jointly may result in lower taxes, but also means that both spouses are responsible for the tax payments, interest, and any penalties, which could be a problem for one spouse if the other spouse was the primary income earner. Information about filing status options for divorced taxpayers is available in IRS Publication 504.
Taking the time to work through these tax consequences as part of your divorce will ensure you are protected financially in the future. Triangle Smart Divorce is here to make sure our clients don’t miss anything when going through a divorce. We see the big picture and know all the little steps you must take to get there.