There is a lot we can account for in life and plan accordingly, but one thing that couples don’t anticipate is the possibility of divorce. When facing a divorce, an individual doesn’t consider the potential long-term tax consequences. During such a stressful and emotional time, preparation for proper tax-planning is a necessity to ensure problems don’t arise in the future, even if those problems are not immediately apparent. Below are concepts that should be considered when tax-planning during a divorce.
Determine the Appropriate Tax Filing Status
A tax filing status is determined by their marital status on the last day of the tax year, usually December 31st. If the divorce has not been finalized by the end of year, a couple should determine if they should file jointly or “married filing separately.” Filing jointly can result in lower taxes for both parties, but there is a risk of both spouses being responsible for the taxes and any interest or penalties due. In a marriage where one spouse makes the majority of the income, this can affect the lower-earning spouse because they can become responsible for higher taxes and penalties than if they were to file separately. Filing separately allows each spouse to report their portion of income, deductions, and credits so responsibility for the associated tax obligation rest with each party.
After the finalization of the divorce, an individual could file as “head of household” if there is a dependent living with them, they are the main residence for that dependent, and provide more than half of the living for said dependent.
Choosing the Appropriate Time to Finalize the Divorce
There are circumstances where finalizing the divorce after December 31st can be advantageous from a tax perspective:
- One spouse earns significantly more income than the other; having to file as single can result in a higher tax bill.
- However, if both spouses are high earners, filing jointly could put them in a higher tax bracket, whereas filing separately would not and can reduce the tax bill for everyone.
Tax Credit
A dependent cannot be claimed by multiple people so divorcing spouses need to understand the rules the IRS use to determine who is entitled to claim the Child Tax Credit. It is usually the spouse who provides support for most of the year. Depending on the divorce agreement, it may be possible to have alternating years to claim the dependent or splitting multiple dependents between each spouse.
Medical Expenses
After the divorce settlement, if you continue paying a child’s medical bills then you can include those cost in your medical expense deductions even if the ex-spouse has custody and claims dependency.
Tax Treatment of Alimony Payments
The Tax Cuts & Jobs Act (TCJA) passed at the end of 2017 has eliminated the alimony payment deductions for divorces after December 31, 2018. However, the alimony-paying spouse who entered into the agreement prior to the legislation can take advantage of the deduction.
Transfer of Property
Property transfers during a divorce are treated as non-taxable, even for federal income and gift taxes. However, foregoing the tax-free treatment that the law allows, and instead intentionally creating a taxable event, even by structuring the transfer as a ‘true sale’ more than one year after the divorce, can have an advantage. For example, the spouse who purchases their ex-spouse’s share to benefit from an increased cost basis on the property.
Also, selling a personal residence that was used as a principal residence for two of the last five years, up to $250,000 (single) or $500,000 (MFJ) may be excluded from capital gains tax.
Recognizing the Value of Tax Carryovers
Negotiation of tax carryovers from capital losses, passive activity losses, net operating losses, and charitable deductions are considered to have inherent value like property and should be discussed when dividing assets and liabilities.
Transferring of Retirement Assets
There isn’t a tax consequence if transfer is structured appropriately as an eligible rollover distribution. But a court must issue a Qualified Domestic Relations Order (QDRO) to make a transfer of part or whole of a qualified retirement plan during a divorce.
The individual receiving funds from a former spouse’s retirement account need to decide whether to keep it in the same plan or whether to roll the funds into an Individual Retirement Account (IRA). It is possible to transfer IRA dollars using a trustee-to-trustee (direct) transfer with no tax consequences if it pertains to the divorce. These transfers must be handled in accordance with IRS regulations to have exemptions from taxes and early withdrawal penalties.
Spousal Support
Alimony payments are common among divorce settlements; however, it may not always be the optimal option. Consider setting up a trust that makes payments to an ex-spouse and if all those contributions within the trust are not fully used then they will revert back to the grantor or be paid out to the children.
Planning for the Future
Thoughtful planning can help avoid future predicaments during divorce settlements. It is best to consider the whole picture with the help of an advisor who can clearly put into perspective the potential benefits and consequences of each decision to create a tax plan that is designed to avoid costly tax consequences.