CHAPTER 6: Taxes
Common Tax Questions Arising in Divorce
The tax questions that come up most often in divorce fall into four general categories:
- What are the tax consequences of property transfers and sales incident to the divorce?
- How are alimony and child support payments treated?
- Which parent gets to claim exemptions and credits related to the children?
- What filing status should the parties claim on their tax return(s) during and after the divorce?
PROPERTY TRANSFERS AND SALES
Transfers of Property between Spouses
As part of the property division, you may need to transfer your ownership interest in some assets to your spouse and vice versa. The transfers of assets and liabilities between spouses as part of a divorce are not taxable. The transfer is treated like a gift. As a general rule, the transfer should occur within a year after the divorce or be pursuant to a divorce judgment or settlement agreement.
Sales of Assets
Some of your assets may be sold and the proceeds distributed between the two of you as part of the property division. Unlike a transfer of owner- ship interests between spouses, the sale of assets may have tax consequences. For example, if a couple sells a property for $100,000 that they purchased for $80,000 they may have to pay taxes on the difference between the sales price and the purchase price. This difference is referred to as a capital gain. If the property is the family home, some or all of the gain on the sale may be tax free. A taxpayer is entitled to exclude from income up to $250,000 of gain on the sale of a principal residence, if the taxpayer:
- Owned and used the property as a principal residence for at least two of the five years preceding the date of the closing of the sale; and Did not exclude gain from the sale of another home during the two-year period ending on the date of the sale.
- Spouses who file separate returns may each exclude up to $250,000 of gain if they each meet the requirements. Spouses who file joint returns may exclude up to $500,000 of the gain if each meets the requirements or if they satisfy special rules for joint returns. Divorcing taxpayers who do not meet the requirements may qualify for a reduced exclusion.
The rules governing when capital gains are taxable can be complex and advice from a tax expert is advised. When properties are going to be sold as part of the divorce process or are expected to be sold immediately after a divorce, the tax consequences should be determined in order to assess their effect on the equity of the marital estate and its division.
Distributions from Corporations
In some cases, one or both of the parties in a divorce can own a part or all of a corporation. There can be significant tax consequences involved in transferring assets from corporations to divorcing parties in order to divide marital estates. Consultation with a financial expert is strongly advised if this type of arrangement appears likely.
ALIMONY AND CHILD SUPPORT
Alimony Payments Under Divorce Instruments Signed after 2018
Under the Tax Cuts and Jobs Act of 2017 (TCJA), alimony payable pursuant to a “divorce or separation instrument” signed on or after January 1, 2019 is not taxable to the recipient or deductible by the payor. A divorce or separation instrument could include: a written separation agreement, a marital settlement agreement, a court support order, or a divorce decree.
This is a significant change from prior law which allowed the payor to deduct the alimony and required the recipient to report it as income. This change in the law does not expire in 2025, as many other TCJA provisions affecting individual income taxation will. Alimony that is paid under a divorce instrument signed on or before December 31, 2018, continues to be tax-deductible. See §6:06.
The elimination of the deduction for the payor spouse may disadvantage the recipient spouse in settlement negotiations as the higher earning spouse loses a powerful incentive to agree to generous alimony. The deduction provided a significant tax benefit for high income earners. See §6:07. Elimination of the deduction is also expected to lead to higher revenues for the government because the payor spouse is usually in a higher tax bracket than the recipient spouse.
Alimony Payments Under Divorce Instruments Signed Before 2019
For divorce instruments signed before 2019, alimony is normally included in the gross income of the recipient and is deductible by the payor. Alimony can be deducted even by taxpayers who claim the standard deduction. Alimony paid pursuant to pre-2019 instruments continues to be deductible regardless of whether the payments are made before or after January 1, 2019.
However, spouses can agree to make alimony payments pursuant to pre-2019 instruments neither taxable to the recipient nor deductible by the payor. This agreement must be expressly set forth in your divorce judgment or marital settlement agreement.
The IRS has rules governing when payments made to an ex-spouse qualify to be treated as alimony. The payments must be cash paid under a divorce or separation decree or agreement. The ex-spouses must live in separate households and file separate returns. The obligation to pay must end with the death of the recipient and the payments must not be designated as child support in the divorce documents.
Once a proposed plan for alimony has been developed or a tentative agreement on the terms of alimony has been reached, your lawyers and tax advisors should assess the payments in light of current IRS regulations to ensure that they will get the tax treatment that you both expected.
Tax Benefits of Alimony Deduction for High Income Earners
The deductibility of alimony results in the taxpayer’s adjusted gross income being reduced by a dollar for every dollar of alimony paid. As a result, the high income earner realizes a tax savings of approximately one- third of the amount of the alimony paid. To put it another way, “Uncle Sam” actually pays one third of the high income payor’s alimony obligation.
Payments to Third Parties as Alimony Under Pre-2019 Divorce Instruments
Payments made to third parties for the benefit of a spouse or former spouse under pre-2019 divorce instruments can qualify as alimony if they meet all of the other IRC factors. This means that one spouse may deduct amounts for some items that benefit the other spouse such as life insurance on the life of the payor when the recipient is the beneficiary, educational expenses paid for the recipient, and even mortgage and real estate taxes paid for the benefit of the recipient.
Child support is neither taxable to the recipient, nor deductible by the payor. The parenting of the children should never depend on the associated tax consequences. You and your spouse should develop your parenting plan first and then deal with the tax consequences.
TAX EXEMPTIONS AND CREDITS ASSOCIATED WITH CHILDREN
Dependency Exemption Eliminated for 2018 through 2026
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminates dependency exemptions beginning in 2018 through 2026; 2017 is the last tax year for which a parent can claim a dependency exemption for a child under 19 or a child 19 or older, but under 24 who is a full-time student for five months during the taxable year. The dependency exemption will resume in 2026 if Congress does not act to extend or modify the law.
Formerly, the divorcing parents could agree on which of them got the exemption in their divorce decree or by filing a Form 8332 with IRS. In the absence of a contrary agreement or allocation by the court, the parent with whom the child lived for more than one-half the tax year was entitled to the exemption.
Divorcing parents with a child under age 8 (or age 13) and their attorneys will need to consider the possibility of the return of the dependency exemption in 2026 when negotiating an agreement with long-term consequences. As in the case of child support, the parenting plan should be developed first and the tax consequences considered later.
Two tax credits are available to parents of certain dependent children. The child tax credit is a credit against tax liability available to parents of children under the age of 17 at the end of the tax year. For tax years 2018 through 2025, the TCJA expanded the child tax credit from $1,000 per year for each eligible child to $2,000.
The credit is phased out for taxpayers who reach certain threshold levels of modified adjusted gross income. Under prior law, the child tax credit phased out for joint taxpayers with income exceeding $230,000, and single, head of household, and married filing separately taxpayers over $115,000. Under TCJA, the child tax credit will not phase out for joint taxpayers under $400,000, or $200,000 for all other taxpayers.
Up to $1,400 (adjusted for inflation after 2018) of the child tax credit is refundable for eligible taxpayers. TCJA also adds a $500 credit for children over age 16.
To claim the credit for tax years before 2018, you must have been entitled to the dependency exemption. See §6:10. With the dependency exemption eliminated, to claim the credit after 2017, you must be the parent with whom the child lived for more than half the tax year. Alternatively, like the dependency exemption, you and your spouse can agree on which of you will get the credit by filing a Form 8332 with IRS or specifying the designation in your divorce decree. The second tax credit is the child and dependent care credit, which is also a direct credit against tax liability. The credit allows you to claim a credit for a portion of employment-related child care expenses (20% to 35% of the expense, up to $3,000 per year for one child, or up to $6,000 for two or more children). This credit is limited to child care expenses for children under age of 13 or for disabled children over 12 years old or other disabled dependents. To claim this credit, you must be the parent with whom the child lived for the greater number of nights during the year. If the child was with each parent for an equal number of nights, you must be the parent with the highest adjusted gross income.
Deduction for Child’s Medical Expenses
Each parent can deduct the medical expenses for a child that the parent paid provided that:
- The child was in the custody of one or both of the parents for more than one half of the year and received more than half of his or her support from the parents:
- The parents are divorced or legally separated; are separated under a written separation agreement; or have lived apart for the last six months of the year.
You must itemize your deductions to deduct medical expenses and they must exceed a certain percentage of your adjusted gross income (7.5% in 2018 and 10% thereafter).
While the Divorce Is Pending
You and your spouse are entitled to file a joint return for the year if you are still married on December 31st. If a divorce judgment is entered prior to December 31st, you are barred from filing jointly for that year Joint filing requires a degree of cooperation that can be difficult to achieve during a divorce, but for most couples it is the option that will result in the lowest tax bill. You can each file separately, but the tax rates for filing separately are significantly higher than those for joint filers.
Filing jointly is not always the better alternative. For example, if one spouse is paying temporary alimony during the divorce pursuant to a divorce instrument signed before 2019, he or she will not be able to deduct the payments from income, nor will the payments be includible in the income of the recipient spouse if the parties file jointly.
Another reason for filing separately may be concern about tax fraud. If you have doubts about the truthfulness of your spouse’s income and expense deduction claims, it might be prudent to file separately. Generally, taxpayers who file joint returns are jointly and severally liable for any tax, penalties, and interest.
Therefore, when dealing with the best tax filing status to choose, a careful analysis of the various filing status possibilities should occur. Your divorce lawyer may refer you to a tax professional for additional advice.
Innocent Spouse Treatment
In some circumstances, the IRC gives “innocent spouses” relief from liability for understatement or underpayment of taxes. The requirements of the Code are complicated. If you have signed joint returns with your spouse and have concerns about the propriety of deductions, income reported, or any other matter indicating intent to understate or underpay income taxes, talk to your divorce lawyer. He or she may refer you to an independent forensic accountant to examine the returns and underlying data, and advise you about seeking innocent spouse relief.
Post Divorce Filing Status
Post divorce, one of you may qualify for head of household status. To qualify as “head of household,” you must be divorced or separated under a decree of separate maintenance at the close of the taxable year, and have maintained the household for a dependent for more than six months of the calendar year. You must have paid more than one-half of the cost of maintaining the household.