Robert Jacobson, CPA, MST
Kutchins, Robbins & Diamond, Ltd. (KRD)
There are numerous factors that influence a couple’s divorce including, education, income levels and even location just to name a few. The fact is about 40 to 50 percent of married couples in the United States divorce, and the divorce rate for subsequent marriages is even higher. If you find yourself in the midst of these statistics, you’ll want to be aware of the following information and how it will impact your tax situation. Plan ahead.
The basics start with your filing status which is used to determine whether you must file a tax return, your standard deduction, and the correct tax. The filing status you can choose depends partly on your marital status on the last day of your tax year. The tax code determines that you are “unmarried” for the whole year if either of the following applies
1) you have obtained a final decree of divorce or separate maintenance by the last day of your tax year or
2) you have obtained a decree of annulment, which holds that no valid marriage ever existed and you must file amended returns for all tax years affected by the annulment that are not closed by the statute of limitations.
If you are unmarried, your filing status is single, or if you meet certain other dependency requirements, your filing status is head of household. If you are married, your filing status is either married filing a joint return or married filing a separate return. The factors used to determine separate maintenance are similar to those determining alimony, and will depend entirely on the laws of your state.
Married Filing Jointly vs. Married Filing Separately. When divorcing, married filing jointly generally has more tax benefits, however, both spouses are jointly and individually responsible for any tax, interest, and penalties due on a joint return for a tax year ending before the divorce, even if the divorce decree states that the former spouse will be responsible for any amounts due on previously filed joint returns. Note that a spouse can ask for relief of these responsibilities under certain provisions.
If a couple is considered married at the end of the year they can choose to file as married filing separately with each spouse reporting only their own income, exemptions, deductions and credits (even if only one had income). Some couples only want to be responsible for the tax due on their own tax return so they choose this method. Note that in almost all situations, couples end up paying more combined federal tax when filing separately compared to filing jointly. Couples have the ability to amend a married filing separately tax return to a joint return within three years of the original filing.
Filing as Head of Household. Head of household generally pay lower taxes than single or married filing separately. To file as such, the individual must meet all the following requirements:
1) You are unmarried or “considered unmarried” on the last day of the year, which means you file a separate return — married filing separately, single, or head of household filing status. Your spouse did not live in your home during at least the last 6 months of the tax year.
2) You paid more than half the cost of keeping up a home for the year. This includes rent, mortgage interest, real estate taxes, insurance on the home, repairs, utilities, and food eaten in the home. This does not include the cost of clothing, education, medical treatment, vacations, life insurance, or transportation for any member of the household.
3) Your home was the main home of your child, stepchild, foster child, or grandchild (or dependent) for more than half the year. You must be able to claim an exemption for the child. You do meet this test if you cannot claim the exemption only because the noncustodial parent can claim the child.
Tax Exemptions for Dependents. You are allowed one exemption for each person you can claim as a dependent. A dependent is either a qualifying child (or qualifying relative). In most cases, because of the residency test, a child of divorced parents is the qualifying child of the custodial parent. The custodial parent can then claim these six tax benefits, provided the person is eligible for each benefit and the noncustodial does not take the exemption or child tax credit:
- The exemption for the child.
- The child tax credit.
- Head of household filing status.
- The credit for child and dependent care expenses.
- The exclusion from income for dependent care benefits.
- The earned income credit.
It is important to note that a child can be treated as the qualifying child of the noncustodial parent if specific rules apply. Discuss your situation with your tax advisor.
Alimony. Alimony is tax deductible by the payer and must be included in the former spouse’s income. A payment to or for a former spouse under a divorce decree is alimony if the spouses do not file a joint return with each other and all the following requirements are met. Note that a couple can designate in their divorce decree that otherwise qualifying payments are not alimony.
1. The payment is in cash – Only cash payments, including checks and money orders, qualify as alimony. The following do not qualify as alimony.
a. Transfers of services or property (including a debt instrument of a third party or an annuity contract
b. Execution of a debt instrument by the payer.
c. The use of the payer’s property.
2. Spouses are not members of the same household. Payments to your spouse while you are members of the same household are not alimony if you are legally separated under a decree of divorce. This requirement applies only if the spouses are legally separated under a decree of divorce or separate maintenance—a payment under a written separation agreement, support decree or other court order may qualify as alimony.
3. There is no liability to make any payment (in cash or property) after the death of the recipient spouse. If any part of payments you make must continue to be made for any period after your spouse’s death that part of your payments is not alimony whether made before or after the death.
4. The payment is not treated as child support. A payment that is specifically designated (or treated as) as child support under your divorce decree is not alimony. The amount of child support may vary over time. Child support payments are not deductible by the payer and are not taxable to the payee.
Note that if both alimony and child support payments are called for by your divorce or separation instrument, and you pay less than the total required, the payments apply first to child support and then to alimony for tax purposes.
Not All Payments Are Alimony. Not all payments under a divorce or separation instrument are alimony (unless they otherwise qualify). Alimony does not include: 1) Child support, 2) Noncash property settlements, 3) Payments that are your spouse’s part of community income, 4) Payments to keep up the payer’s property, or 5) Use of the payer’s property.
Life Insurance Premiums. Alimony includes premiums you must pay under your divorce decree for insurance on your life to the extent your spouse owns the policy.
Amended Divorce Decree. Divorce decree amendments are not ordinarily retroactive for federal tax purposes. However, a retroactive amendment to a divorce decree correcting a clerical error to reflect the original intent of the court will generally be effective retroactively for federal tax purposes.
Recapture of Alimony. If alimony payments decrease or end during the first 3 calendar years, you may be subject to the recapture rule where the payer may be subject to a recapture of income from the alimony deduction taken and the payee may be eligible for a tax deduction.
Nonresident Aliens Tax Withholding. If you are a U.S. citizen or resident alien and you pay alimony to a nonresident alien spouse, you may have to withhold income tax at a rate of 30% on each payment. However, many tax treaties provide for an exemption from withholding for alimony payments.
Spousal IRA Contributions and IRA Transfer. If you get a final decree of divorce by the end of your tax year, you cannot deduct contributions you make to your former spouse’s traditional IRA. The transfer of all or part of your interest in a traditional IRA to your former spouse, under a decree of divorce, is not considered a taxable transfer. Starting from the date of the transfer, the traditional IRA interest transferred is treated as your former spouse’s traditional IRA. These rules only apply to traditional IRAs – not Roth or SIMPLE IRAs.
IRA Contribution and Deduction Limits. All taxable alimony you receive under a decree of divorce is treated as compensation for purposes of making contributions to your IRA and for purposes of applying the deduction limits for traditional IRAs.
Transfer of Property Between Spouses & Transfers in Trust. Generally, there is no recognized gain or loss on the transfer of property between spouses, or between former spouses if the transfer is because of a divorce. Although generally you don’t have to recognize the gain or loss on the transfer, you may have to report the transaction on a gift tax return. Additionally if you make a transfer of property in trust for the benefit of your former spouse, if incident to your divorce, you generally do not recognize any gain or loss. However, you must recognize gain or loss if, incident to your divorce, you transfer an installment obligation in trust for the benefit of your former spouse.
Transfer Health/Medical Savings account (HSA/ MSA). If you transfer your interest in an HSA or Archer MSA to your former spouse under a divorce, it is not considered a taxable transfer. After the transfer, the interest is treated as your spouse’s HSA or Archer MSA respectively.
Basis of Property Received. Your basis in property received from your former spouse, if incident to your divorce, is the same as your spouse’s adjusted basis. This applies for determining either gain or loss when you later dispose of the property.
Sale of Jointly-Owned Property. If you sell property that you and your spouse own jointly, you must report your share of the recognized gain or loss on your income tax return for the year of the sale. If you sold your main home, you may be able to exclude up to $250,000 (up to $500,000 if you and your spouse file a joint return) of gain on the sale.
Legal Fees vs. Legal Fees for Tax Advice. You cannot deduct legal fees and court costs for getting a divorce. But you may be able to deduct legal fees paid for tax advice in connection with a divorce and legal fees to get alimony. You can deduct fees for advice on federal, state, and local taxes of all types, including income, estate, gift, inheritance, and property taxes. In addition, you may be able to deduct fees you pay to appraisers, actuaries, and accountants for services in determining your correct tax or in helping to get alimony. Couples should request a breakdown showing the amount charged for each service performed. You can claim deductible fees only if you itemize deductions– subject to the 2%-of-adjusted-gross-income limit.
Nondeductible Legal Expenses. You cannot deduct the costs of personal advice, counseling, or legal action in a divorce. These costs are not deductible, even if they are paid, in part, to arrive at a financial settlement or to protect income-producing property. However, you can add certain legal fees you pay specifically for a property settlement to the basis of the property you receive. For example, you can add the cost of preparing and filing a deed to put title to your house in your name alone to the basis of the house. You cannot deduct fees you pay for your former spouse, unless your payments qualify as alimony. If you have no legal responsibility arising from the divorce settlement or decree to pay your spouse’s legal fees, your payments are gifts and may be subject to the gift tax.
Tax Withholding and Estimated Tax. When you become divorced, you will usually have to file a new Form W-4 with your employer to claim your proper withholding allowances. If you receive alimony, you may have to make estimated tax payments. If you do not pay enough tax either through withholding or by making estimated tax payments, you will have an underpayment of estimated tax and you may have to pay a penalty.
Community Property. If you are married and your permanent legal home is in a community property state, special rules determine your tax ramifications. The community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
These are the general rules that apply to divorcing couples; however, there are many exceptions to the tax code. For further assistance on the tax rules associated with divorcing couples, please contact:
Robert Jacobson at KRD- Kutchins, Robbins & Diamond, Ltd. CPAs: 847-278-4367, firstname.lastname@example.org