Attorneys and accountants should recognize the common tax issues that occur in a divorce. These issues include filing status and dependency matters, alimony and child support, and property settlements. Each of these issues impact how a settlement is reached in each individual case.
Filing Status
It is imperative that parties to a divorce have a clear and concise understanding of what filing status is available to them during the divorce and after they divorce. Filing status for tax purposes is determined on the last day of a tax year, generally December 31. During the divorce proceedings, a couple – although they may be living in separate households – for tax purposes may still be considered married at year end.
There are four filing statuses an individual may use while going through a divorce. Married individuals may choose between married filing jointly, married filing separately or head of household if the requirements to choose this status are met. Divorced individuals have a choice between single or head of household. In making the filing status choice, it will be determined based on whether the divorcing couple is still married on the last day of the year.
A marriage is considered terminated for tax purposes when a final decree of divorce has been issued by a family court or if the family court has issued a final decree constituting a legal separation under state law. Therefore, if a legal decree has not been issued, a taxpayer may file either married filing jointly or separately.
Married filing jointly generally produces the lowest tax burden; however, it will be crucial that both parties cooperate in providing information to provide a complete and accurate tax return. If there is underreporting of income, the Internal Revenue Service could assess underpayment penalties and interest in addition to tax. In addition, if a divorce is finalized toward year end, both parties should review whether it may make sense to have the divorce become final in January so they can file a return using the married filing jointly status, as it may be advantageous to both parties.
After the divorce, an individual who has custody of a child may qualify to use the head of household filing status. To qualify to use head of household status, the taxpayer must meet the following requirements:
Be unmarried for tax purposes;
a. Maintain a home for an unmarried
b. qualifying child for more than half of the year. That home must be the child’s principal home; and
c. Pay more than half of the cost of maintaining the home
In addition, to qualify for head of household status, the custodial parent does not have to claim a dependency exemption for the child.
A planning tip for practitioners to consider, if there is more than one child from the marriage, is to include language in the divorce agreement that suggests each spouse is the custodial parent of one child so both parties can qualify to use head of household status.
Child-Related Deductions and Exemptions
When children are part of a dissolving marriage, there are a few issues that need to be considered and addressed. The following is a list of custody decisions:
a. Dependency exemptions for custodial and non-custodial parents
b. Child care credits
c. Child tax credits
d. Medical deductions for dependent children
e. Education tax credits – Hope and Life time Learning credits
There are certain tests that need to be satisfied to have a child qualify for a dependent. The following requirements must be met:
a. Residency
b. Relationship
c. Age
d. Self-support
Custody is determined by the parent who has physical custody of the child for the greater portion of the year. In some cases, it may be more advantageous to allow the spouse with a higher income tax rate to claim a child as a dependent if they meet the other income limitations to claim the child as a dependent.
Form 8332 (Release of Claim to Exemption for Child of Divorced or Separated Parents) may need to be included in a non-custodial parent’s return. However, a tax law change in the Working Families Tax Relief Act of 2004 no longer requires Form 8332 if the non-custodial parent is entitled to the child exemption
Many of the above exemptions, deductions and credits have income limitations associated with them. Each individual’s tax situation should be carefully analyzed to produce the best tax result.
Property Settlements
A divorcing couple have to decide how to divide property. Many factors are involved with this decision. First, ownership needs to be determined, as assets are accumulated before and during the marriage. Property settlements incident to a divorce are tax free transfers under Internal Revenue Code 1041. Therefore, no gain or loss occurs that triggers a taxable event. Basis of the property is important, as well as whether any liability is attached to an asset when a divorce occurs. In the event property received in a divorce is sold following the divorce, a taxable event could occur if a gain is recognized. A spouse who receives an asset with a low cost basis compared to its fair market value (for example, shares of stock that have appreciated) needs to be informed of the tax liability that they assume by receiving this type of asset.
Planning for the Marital Home
A personal residence frequently is one of the most valuable assets of a couple. Careful consideration should be exercised when deciding who receives this asset. As real estate prices have increased, some couples may have a gain on the sale of their home. While a law change in 1997 helped ease this burden, it should be considered in the property divisions. Married couples who sell their personal residence do not recognize a gain on the sale if the gain is under $500,000, as long as the residence was their principal residence in two of the prior five years. However, single individuals or those filing married filing separately can defer only $250,000 of the gain. There is no step up in the cost basis of the home at the time of the divorce.
Alimony
Another consideration in a divorce is whether alimony may occur. The spouse who receives alimony has taxable income. The spouse who pays the alimony receives a deduction. Child support is not included in income, nor is a deduction allowed for its payment. The spouse who receives alimony may qualify to contribute to an IRA (individual retirement account). An allocation between alimony and child support will need to be evaluated in each individual situation.
Taxes and Tax Carry Forwards
A well-written decree should clearly state each spouse’s responsibility in regard to the tax liability, and a clause should be included in regard to indemnifying each spouse to the other spouse’s tax liability. In addition, the decree should include the division of how the couple should handle income, capital gains or losses, mortgage interest, real estate and property tax, and charitable contributions in the year the divorce is finalized so they may use it for their tax returns. Also, if there are any tax carry forwards – for example, a capital loss carry forward, a charitable contribution carry forward, a net operation loss carry forward or a minimum tax carry forward – these tax attributes must also be considered. In the event a couple owned passive income producing property, there could also be suspended passive activity losses that could be carried forward to another year. Generally, a tax carry forward is awarded to the party who received the property. Many planning opportunities arise in regard to property settlements regarding this type of property.
As a reader, one can see that there are many tax-related issues that arise from a divorce. It is important that any couple who goes through a divorce seek qualified advisors who can interpret these issues and provide the best and most equitable settlements to both parties.
Courtesy of http://www.mobar.org