Divorce is challenging. Navigating both the emotional and financial complexities of a divorce can be difficult since divorce is not something a person regularly goes through. Some helpful news, though, is that facing the impact of marital dissolution on your tax situation is something a little advance knowledge can assist with. CBM’s divorce financial planning team has provided the following insights to make managing a tough situation a little easier. Easier does not mean easy. Should you have questions about ways to strategically manage your tax situation, please feel free to contact us.
Filing Status
Your marital status on December 31 of the tax year will determine your filing status for that year. If your divorce has been finalized before the end of the year, you will file as single or as head of household. You are eligible to apply for the latter if you pay more than half the cost of keeping up a home for yourself and a qualifying person (such as one or more dependents) and meet other criteria. Filing as head of household provides a favorable tax rate and a higher standard deduction than an individual filing as single.
If your divorce is still in process at the end of the calendar year, however, you will need to file as either married filing jointly, married filing separately, or head-of-household. You may only file as head-of-household while you are still married if you meet the following specification to be “considered unmarried”:
(1) file your tax return for the tax year separate from your spouse;
(2) paid more than 50% of the cost for keeping up your home;
(3) lived apart from your spouse for the entire last 6 months of the tax year. Please note that your spouse is considered to have lived in the home even if temporarily absent due to special circumstances (i.e., military service or education);
(4) provided the main home for more than 50% of the year to a dependent child, stepchild, or foster child. The 50% test for a dependent can also be met if you cannot claim the exemption only because the non-custodial parent can claim the dependent child using the rules outlined in Publication 17, which provides rules for filing your tax return.
One benefit to consider by filing as married filing jointly is more favorable tax rates and a higher standard deduction.
Alimony
The taxability of alimony went through a notable change following the 2017 passage of the federal legislation known as the Tax Cuts and Jobs Act. According to the new legislation, any alimony payment for a divorce finalized after December 31, 2018, is no longer tax-deductible to the person paying alimony or taxable to the person receiving alimony as it had been in the past. While that means the taxable income of the person paying alimony is not reduced, the person receiving alimony receives tax-free income. Before the legislation passed, that individual did need to report the alimony for tax purposes. Now, however, they do not need to report alimony. Alimony recapture rules for divorces finalized after December 31, 2018 no longer apply. If their divorce was finalized before December 31, 2018 their alimony tax treatment still falls under the old rules.
Child Support
Child support payments are not tax deductible to the payor or taxable to the recipient. It is important to distinguish child support from alimony since the latter was impacted by the Tax Cuts and Jobs Act (by removing the deductibility of alimony for the payer for divorce agreements filed after December 31, 2018) while child support payments could never be deducted.
It is also important to note that child support payments do not affect eligibility for certain tax credits such as the Child Tax Credit or the Earned Income Tax Credit, which are based on other criteria such as household income and the number of qualifying children in the household.
Property Division
Property impacted by a divorce can include many kinds of assets and liabilities such as retirement accounts and real estate, which each carry varying tax implications. Property transfers between spouses are tax-free though the recipient will be responsible, when selling at a future date, for capital gains tax on the appreciated value of the property. Similarly, if a retirement account is split as part of a divorce by means of a trustee-to-trustee transfer there is no taxable income on the transfer. Future withdrawals from the account, will be taxed if it is a pre-tax account. (Read more below).
Dependency Exemptions
If you and your ex-spouse have children, one of you will be eligible to claim them as dependents for tax purposes. The custodial parent who provides housing for the child(ren) more than half of the tax year typically has the right to claim the dependency exemption. However, this can be negotiated. A custodial parent can also sign IRS Form 8332 and agree to waive his/her right to the dependency exemption, thereby allowing the non-custodial parent to claim it.
Retirement Accounts: A Helpful Strategy for Tax Purposes
As mentioned above, a retirement account is a kind of asset whose pre-tax value can trigger tax and possible early distribution penalties when cashed out. Qualified retirement plans such as a 401(k) or 403(b) require a legal document termed a qualified domestic relations order (QDRO) to transfer a portion of the employee’s account to their spouse. When retirement assets are distributed from a qualified plan via QDRO the recipient spouse may meet a one-time exception to the early withdrawal penalty. The funds they distribute rather than roll over into another retirement account will still be subject to income tax.
A word of warning: Setting up a QDRO can be a complex task so please consider seeking professional assistance.
Some Closing Thoughts: Divorce and Tax Planning
A portion of legal fees related to the divorce process may be tax-deductible if related to tax advice or the operation of your business. They may be capitalized and added to basis if related to the preservation of a capital asset. Please consult with your tax advisor to see if this will apply in your circumstance.
Finally, it is usually the case that divorce leads to changes in your finances, which could have ripple effects by also impacting your eligibility for tax deductions and credits. Tax planning related to divorce does not end when the marriage ends. It is important to pay attention to and carefully review the terms of the Marital Settlement Agreement for future tax impacts. No one wants to go through a divorce, but if you do, be sure to understand the implications for your tax situation.
CBM has assisted numerous divorcing individuals navigate complex areas of financial and tax planning for more than 35 years. If you need assistance, please contact Jane Ochsman Rowny via our online contact form.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
