Dividing assets and property fairly is one of the most contentious processes in many divorces. Beyond the standard question of who gets what, it’s essential to recognize that the division of these assets can often have tax implications, which is why it is usually recommended to consult with a divorce tax accountant early in the proceedings. Here are some of the most common tax-related issues that come up during a divorce.
Division of Property
Property settlements between spouses are not treated as sales, meaning that there is no immediate gain or loss to be reported on the tax return. However, any gain or loss would be taxed accordingly when sold. This should be taken into consideration while determining the equitable distribution of property.
Primary Residence
Sale of a marital home should be considered early in the divorce proceedings, as the equitable division of this property may become extremely complex, particularly if there is substantial equity in it. If both parties agree that a sale is the best route and they have lived in the home for two of the previous five years (may be extended up to ten years under certain circumstances if either spouse is in the military) the capital gain exclusion is $500,000 for a married couple; it is only $250,000 for an individual. As such, the timing of the sale can have considerable differences in tax treatment (i.e. if sold before or after the divorce.)
Alimony and Child Support
Alimony/maintenance is no longer taxable for the recipient nor deductible for the paying spouse. Child support is also not deductible.
Filing Status
Filing status is based upon the couple’s standing at the end of the year. Couples that are still legally married may file jointly, or as married filing separate. When filing jointly, each party is jointly liable for the tax obligation. If the couple is divorced as of December 31, then they must file as single or as head of household, if they qualify. For couples that are married, but legally separated, they may be able to file as head of household if they have not lived together for the last six months of the year and they meet all other head of household qualifiers.
Family Court Rulings
Family court rulings may sometimes contradict federal tax law. One common example occurs when one parent is awarded physical custody while the other is granted the right to claim the child as a dependent; this is not allowed under federal tax law. If both parties agree to this arrangement though, the custodial parent may provide the noncustodial parent with an IRS form allowing this arrangement.
Claiming Dependents
Divorced spouses frequently believe that a choice can be made when determining who can claim a child for tax purposes. However, federal tax law is very specific regarding what criteria must be met for a parent to claim the child. Tax rules addressing this can become very complex because they often impact a variety of different tax benefits, such as the child tax credit, the earned income tax credit, filing status, child care credits, and tuition credits.
Retirement Accounts
Designating a portion of a qualified retirement plan to a spouse is accomplished through a Qualified Domestic Relations Order (QDRO). This ensures that the benefits are taxed when the distributions are made, not when the QDRO is established and assures the assignee spouse immediate ownership.
IRAs, Deferred Compensation and Stock Options
IRA’s are not covered under QDROs, and those transferred before or pursuant to the divorce or separation agreement are not considered a taxable event. This is also true for the transfer of interest on stock options or deferred compensation plans. Income is reported upon payment to the recipient.
Social Security Benefits
Divorced individuals may be eligible to receive Social Security benefits based upon a former spouse’s income provided that the duration of the marriage was at least ten years, the former spouse is 62 or older and unmarried, and the anticipated benefit exceeds what the individual would receive based upon their own work.
These issues are some of the most commonly-encountered tax-related questions that come up, but there are undoubtedly many others that can apply under certain circumstances, including how to deduct mortgage interest or property taxes and what conditions would exempt an individual from the responsibility of tax liabilities attributed to their spouse.
Tax law is complex, and divorces are frequently complicated as well. Taken together, this often confuses both parties and frequently, can result in the realization that there were missed opportunities to put both parties in more advantageous financial and tax positions. Consulting with a divorce tax accountant prior to the onset of proceedings is often the best, if not only, way to truly optimize the agreements in a way that can benefit both parties.
A full-service Certified Public Accounting Firm located in Denver, CO Shuster & Company, PC provides quality, personalized financial advice and guidance to individuals, businesses and the legal community. We offer an extensive range of services, with emphasis in forensic accounting, divorce consulting, business valuation, and litigation support.