How Matters Affect the Bottom Line in Divorce Tax Planning
By TOM CROGAN
Divorce patterns have changed considerably in recent years. A recent New York Times article stated that the divorce rate is no longer rising. That trend, the report noted, is the result of people getting married later in life and also the feminist movement; as women entered the workforce, marriage began to evolve into its “modern-day form based on love and shared passions, and often two incomes and shared housekeeping duties.”
If you’re going through a divorce, though, the last thing on your mind is how the divorce will impact your next tax return. This article focuses on the income-tax issues of alimony, child support, and property settlements in most largely unplanned divorces.
Alimony (IRC Section 71)
Alimony is a payment to or for a spouse or former spouse under a divorce or separation instrument. It does not include voluntary payments that are not made under a divorce or separation agreement.
Alimony is deductible by the payer and included in the income of the recipient. IRC Section 71 defines alimony as the transfer of cash made under a divorce or separation instrument. The payments must meet the following criteria:
• The payments must be in cash and must be received pursuant to a divorce or written separation instrument;
• The spouses must reside in separate households;
• The payer’s liability must not continue after the payee’s death;
• The payer and payee must file separate tax returns;
• The divorce or separation instrument must not designate non-alimony treatment; and
• The divorce or separation instrument does not indicate that such payment is not includable in the recipient’s income and not deductible by the payer.
Not all payments under a divorce or separation agreement are alimony. Alimony does not include child support, non-cash property settlements, or payments to keep up the payer’s property.
Generally, a payment is for child support when a divorce decree specifically designates all or part of a payment as being for child support. Child-support payments are not deductible by the payer and are not taxable to the recipient.
A payment will be treated specifically designated as child support to the extent the payment is reduced either on the happening of a contingency relating to your child, such as the attainment of a certain age, marriage of the child, death, leaving school, or becoming employed.
A related issue to child support is deciding which parent receives the dependency exemption for the child. Assuming all of the dependency exemption requirements are met, the parents can decide for themselves. Often the divorce decree will dictate which parent takes the dependency deduction.
Property Distributions (IRC Sec 1041)
For divorcing couples, the distribution of property is often the most important aspect in a divorce. This is especially difficult if there are significant assets such as houses, retirement plans, a closely held business, or rental property. You need to understand which assets will fit your financial goals best.
You also need to understand the liquidity of the asset, cost basis, and income-tax implications associated with the sale of the asset.
IRC Section 1041 provides favorable treatment to divorcing spouses when it comes to distributing property. Under Sec. 1041, property transferred between divorcing spouses is generally treated as a gift. Cost basis and holding period carry over, and the transfer most often avoids treatment as a taxable event.
Other Tax-planning Opportunities
Dependents: You can continue to claim your child as your dependent if the divorce decree names you as the custodial parent. If the divorce decree is silent on the fact, the parent whom the child lived with for a longer period of time during the year can claim the child as a dependent.
It’s still possible for the non-custodial parent to claim the dependency exemption if the custodial parent signs a waiver not to claim the child as a dependent for that particular year.
The parent who claimed the child as the dependent is the one who is entitled to claim the child tax credit, American Opportunity credit, or Lifetime Learning credit. If you can’t claim the dependency exemption, you can’t claim the credits even if you paid the college expenses.
You can claim the child-care credit for work-related expenses you incur for the care of your child, under age 13, if you have custody, even if your ex-spouse claims the child as a dependent.
Retirement Accounts: If you cash out a 401(k) account to give the money to your spouse, the amount is taxable to you as a distribution. You can avoid this trap by having the transfer treated under a qualified domestic relations order (QDRO). This allows you to give the money to your spouse and relieves you of the tax burden of having it treated as a taxable distribution. QDROs are very complex, and great care and consideration should be given to any QDRO created in a divorce.
An IRA that is transferred is treated differently. As long as the transfer is spelled out in the divorce settlement, the transfer is not treated as a taxable distribution. Instead it is treated as a rollover and not subject to the 10% penalty.
Home Sales: In general, the tax law allows a $250,000 capital-gain exclusion if you are single or married filing separately, and a $500,000 exclusion if you are married and owned the home and lived there for two of the past five years and the home is your primary residence.
For sales after the divorce, if the two-year and five-year ownership and use test is met, you are limited to the $250,000 capital-gain exclusion.
Tom Crogan is a manager at South Hadley-based Pieciak & Company, P.C. and has been involved in performing business valuations, litigation support, and consulting with small business to help them solve their tax and accounting issues.