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Divorce

Divorce is a trying time. You work with lawyers on the legal issues but you should also get professional tax advice. And with Texas being a community property state, the tax consequences are more important. Before you sign anything, make sure you understand the tax consequences as well as the legal ones. Tax consequences follow every decision made in a divorce. Even when the choices are limited, knowledge of the tax problems created by the divorce may help achieve a better settlement.

Alimony vs Child Support
Alimony vs Loan Payments
Exemptions for the Children
Child Care Credit
Capital Gains on Your House
Filing Status
Timing of the Divorce
Tax Payments
Statue of Limitations
Change of Address
Other Tax Considerations

Alimony vs Child Support
Periodic alimony is included in the taxable income of the recipient and it is tax deductible to the payor. Child support is not included in the taxable income of the recipient and it is not tax deductible to the payor. So all other things being equal, payors want as much of support as possible to be alimony and recipients want as much of support as possible to be child support.

But all other things usually are not equal, in particular the incomes of the payor and the recipient. When the payor's income is considerably higher than the recipient, there may be an advantage to both spouses to paying alimony rather than child support, because the tax advantages of alimony allow the payor to increase the after-tax support level to the recipient.

It's not unusual in divorce for the higher-income spouse to agree to pay additional incidental expenses of the other spouse for years, sometimes indefinitely. These are things like medical insurance, life insurance on the payor's life, home mortgage payments, and car payments. In these cases, it is usually smart to take the time to ensure that the payments for each expense qualify as alimony.

The same principle applies to the payments that the payor often makes to the recipient in a one time property settlement in connection with the divorce itself. It is often better for both spouses, if these can be paid in the form of periodic alimony. Again, the payor may need to increase the payments to compensate the recipient for the cost of the taxes, and both spouses can end up with more money to spend. Because it is better for many couples to pay and receive support in the form of taxable alimony, the government has set up restrictions.
1. Excess alimony - make sure alimony is not "front-loaded" - too concentrated in the period immediately after the divorce.
2. Alimony fixed as child support - make sure the alimony isn't reduced or eliminated on a date corresponding to a date when one or more of the children reaches one of several specified ages.

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Alimony vs Loan Payments
Structuring alimony payments is important when payments of joint liability loans are involved. Your alimony deduction is cut by half of any loan payments made even if the divorce decree requires you to make the mortgage payments. That's because one-half of the payment is discharging your own loan obligation. (Harris, Tax Court Summary Op. 2007-169).

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Exemptions for the Children
Most divorcing couples are aware of the exemptions for the children, and it is typical for each spouse to believe that he or she is entitled to them. The IRS assumes the spouse who has custody of the children is entitled to the exemptions, but the spouses are allowed to trade them back and forth freely, using form 8332. The Tax Reform Act of 1997 includes the right to use the Child Credit, Hope Scholarship and Lifetime Learning Credit to the Taxpayer with the exemption. When there are multiple children, one option parents often use (usually the wrong one) is for the spouses to split the exemptions. This may feel fair to both spouses, but the spouses are never better off to share the exemptions, and if one spouse's income is substantially higher than the other's, the spouses will be worse off, because they will have missed a chance to maximize tax savings.

The better approach with exemptions is to consult an expert on tax in divorce who can calculate the value of the exemption(s) to each spouse. The one who can make better use of the exemption(s) should take all of them, and if appropriate, compensate the other spouse.

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Dependent Care Credit
The parent who has custody of the children is entitled to claim a credit of 20% to 35% of the cost of work related child care, up to a maximum of $2100 for two or more children under the age of 13. Unlike the exemption, the Dependent Care Credit can't be traded; it is available only to the custodial parent. IRS Form 8332 has no effect on the ability to claim the credit for child care expenses.

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Capital Gains on Your House
Capital gains was a big issue until recently. The August, 1997 tax bill effectively does away with capital gains tax on the sale of your principal residence for the vast majority of homeowners. The new tax law defines a principal residence as the home where you've lived for any two of the last five years. If you sell your principal residence anytime on or after May 7, 1997, you are allowed to exclude up to $500,000 for a married couple. The new tax law says that if you move out of the house and your spouse has the right to live in it pursuant to a divorce or written separation agreement, your spouse's residence in the house will be counted as your residence for purposes of calculating the two year residence requirement.

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Filing Status
Your marital status for tax filing is set on the last day of the year. It depends on your marital status and your family status as of December 31.

If you are divorced as of December 31, you must file as single taxpayers for that year, even if you and your spouse lived together as a married couple more than half the year.

If you are still married as of December 31, you and your spouse lived in the same household and were not legally separated, you must file as married (either a joint return or separate returns). You may be able to file as Head of Household even if you were legally married on December 31.

You are considered unmarried, if you were legally separated on December 31 or if your spouse did not live in your home for the last six months of the year.

Usually (and there are exceptions), the tax rates get higher in the following order: married filing jointly (lowest), head of household, single, married filing separately (highest).

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Timing of the Divorce
Because the marital status of the parties for purposes of their tax return is set as of the last day of the year, a couple contemplating divorce near the end of the year should consider whether they would be better off making their divorce effective before the end of the year - allowing them to file as single taxpayers, or making their divorce effective after the end of the year - allowing them to file a joint return.

One caution about filing jointly. The less financially savvy spouse needs to understand that signing a joint return with his or her spouse exposes him or her to liability, even if he or she is not privy to all the calculations included in the return. Because trust is often at a low as divorcing couples are preparing their final joint return, the less financially savvy spouse should consider hiring an independent tax professional to review the return and its supporting documents before signing it.

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Tax Payments
Texas is a community property state. On withholding, each spouse is entitled to one half of the withheld taxes. But estimated tax payments are treated differently. On a joint declaration, then the spouses share the estimated tax payment. But if a separate declaration is made by one spouse, then the IRS credits the payment to the spouse making the declaration. This is true even if the payment is made with community income.

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Statue of Limitations
The statue of limitations is important to consider. The IRS generally has 3 years to audit after a tax return is filed. The divorcing spouses should understand that the IRS is not bound by the divorce decree. Even if one spouse has agreed to be liable for taxes assessed by the IRS after the divorce for years the spouses were married, the IRS will attempt to collect from the spouse who has assets and can pay. The last three years of tax returns should be reviewed to verify they were filed, tax liability paid and determine audit potential. If it is determined a tax liability may exist, the divorce decree should provide for a reserve for the potential taxes.

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Change of Address
Make sure you notify the IRS of any change of address. Form 8822 should be sent to the IRS. You want to ensure you get copies of any IRS correspondence.

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Other Tax Considerations
There are more important things to consider - property transfers, transfers and redemptions of stock “on behalf of” a spouse, transfers of Individual Retirement Accounts (IRAs), Qualified Domestic Relations Orders, interest and dividends, life insurance, taxes and business valuation, etc. You need to request transcripts from the IRS to make sure your joint tax returns have been filed and the tax liability paid. Even how the divorce attorney documents the bill can be a tax deduction. Double checking with a tax professional before signing your divorce decree is wise.

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Tax Savvy
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Wylie, TX 75098
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CheriPullen@TaxSavvy.biz

The information you obtain at this site is not, nor is it intended to be, tax advice. You should consult a licensed tax professional for individual advice regarding your own situation.