Tax Implications of Divorce

Typically, the Internal Revenue Service (IRS) does not consider the transfer of assets between spouses who are divorcing to be a taxable event. However, individuals who are not aware of the tax implications of their divorce may later stand to lose a great deal of money and assets if they are not aware of what those implications are.

What are some Commonly Taxed Items and Events that I Should Look Out for?

There are numerous big ticket items that an individual should be aware of when they are considering the tax implications of a divorce. Failing to consider these tax implications in advance may cause the spouse who retains the asset to be required to sell it in order to pay the taxes.

The family home is typically the most expensive asset that a couple owns. Upon a divorce, the couple may end up with one of the following three solutions for distributing the home, including:

• Immediately selling the home and dividing the proceeds;
• Selling the home at a future date; or
• One spouse purchasing the other spouse’s interest in the property.

If the spouses are under the age of 55 and the home is their principal residence, taxpayers have a two year window in which to reinvest their money to avoid capital gains tax. Problems may arise when one ex-spouse lives in the home for more than two years following the divorce.

Large capital gains may be taxed on the other spouse if the home is eventually sold as the principal residence rule no longer applies. If the spouses are over the age of 55, the process of selling may be more complex.

A couple over 55 qualifies for capital gains exclusions up to $125,000. If the couple waits until after the divorce, each will qualify for a $125,000 exclusion, which results in a $250,000 combined tax shelter.

If their home is worth more than $125,000, the parties should wait until after divorce to sell it. There are also other items that may be affected, including:

• Mutual funds;
• Stocks;
• Bonds;
• Artwork; and
• Other appreciating items.

Appreciating assets or belongs which many couples collect are required to be distributed and divided during a divorce. Typically, a stock would be taxed on its gains over the period of the investment.

In a divorce buy-out setting, where one spouse buys the other’s interest, however, the spouse would pay taxes on the original investment. They would not be taxed on the total investment funds that were used to buy out their former spouse.

The money that is paid to the other spouse, however, goes to them tax-free. Retirement funds are another major financial issue that arises during a divorce.

The tax laws that govern retirement plans are strict. These laws govern not only the individual that receives the distributions but also how they are handed out.

These laws governing the plan owners’ spousal rights are also strict. An individual’s ex-spouse is entitled to a certain portion of the distribution plan.

An IRA, on the other hand, is generally considered the property of its owner. This assumes that there were no contributions from earnings that were made during the marriage.

It is important to note that there is a dependency exception which applies to a custodial parent. It provides them an exemption when filing taxes.

This is typically more important for a lower-to-middle-income taxpayer, especially if there is a significant difference between the earnings of the two individuals who are seeking the divorce. Regardless of custody, both parents are permitted to deduct medical expenses.

What is Innocent Spouse Tax Relief?

Generally, many married couples will file a joint income tax return when filing their taxes each year. This is, in part, because filing a joint income tax return offers a variety of tax benefits to married taxpayers.

If a couple files a joint return, both spouses may be held liable, either independently or jointly, for any taxes, tax interest, or penalties that are associated with the joint income tax return. One spouse may be held liable if the couple files for divorce at a later time.

For example, one of the spouses may be held legally responsible for the full amount of the taxes that are owed. This applies even in cases where the other spouse was actually the one responsible for the debt and owes the tax.

In certain cases, one spouse may be able to claim relief by requesting that they be declared an innocent spouse. If an individual can prove they should receive innocent spouse tax relief, it will essentially release them from the responsibility of paying any additional taxes that belong to the other spouse which are owed on the joint tax return.

What is Alimony or Separate Maintenance?

A payment qualifies as alimony or separate maintenance if all the following requirements are mat:

• The spouses did not file a joint return together;
• The payment is made in cash, which may include a check or money order;
• The payment is for or to a spouse or a former spouse which is made under a divorce or separation instrument;
• The spouses are not members of the same household at the time the payment is created;
  • This requirement only applies when the spouses are legally separated pursuant to a decree of divorce or separate maintenance;
• There is no liability to make the payment in cash or property after the death of the recipient spouse and;
• The payment is not treated as a property settlement or as child support.

It is important to note that alimony or separate maintenance does not include:

• Child support;
• Property settlements that are not case, whether they are in a lump sum or in installments;
• Payments that are the other spouse’s portion of community property income;
• Payments to keep up the payer’s property; and;
• Use of the payer’s property.

What is the Tax Treatment of Alimony and Separate Maintenance?

For federal tax purposes, an amount that is paid to a former spouse pursuant to their divorce or separation instrument may be considered alimony or separate maintenance payments. A divorce or separation instrument may include:

• A divorce decree;
• A separate maintenance decree; or
• A written separation agreement.

Some alimony or separate maintenance payments are deductible by the paying spouse. The recipient spouse is required to incorporate them into their income.

How do I Report Taxable Alimony or Separate Maintenance?

If an individual makes a payment that is considered taxable alimony or separate maintenance, they are permitted to deduct that amount from their income whether or not they itemize their deductions. There are different forms available on the IRS website related to these issues.

The spouse deducting these amounts must enter the Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN) of the spouse or former spouse receiving the payments. If this information is not provided, the deduction may be denied and the deducting spouse may be required to pay a $50 penalty.

If a receiving spouse has received amounts that are considered taxable alimony or separate maintenance, they must include the amount of alimony or separate maintenance they received as income.

Should I Contact a Lawyer Regarding the Tax Implications of My Divorce?

The tax implications of divorce are far-reaching. It is important to consult with a divorce lawyer if you want to maximize your assets and your chances of retaining them after the divorce.

Your lawyer will advise you regarding the tax implications of different possible choices regarding marital property as well as the best structure for your divorce. Having an attorney will help protect your rights and your assets during the divorce process.