Divorce is a troubling issue and a difficult time for all those involved. Unfortunately the tax rules do not make things any easier. In this article we will provide you with some information that may assist you. We are going to cover:
• Tax filing rules
• Alimony and other support payments
• Primary residence
• Retirement assets
• Other property transfers
Tax Filing Rules
Filing Status
Your marital status for tax filing purposes is set as of the last day of the year. If you are divorced as of December 31st you must file as a single taxpayer for that year, even if you and your spouse lived together as a married couple for a portion of the year.
If you were married at December 31st the rules are more complicated, you can file married filing jointly, married filing separately, and in certain instances as head of household. The tax rates are set so that the most favorable tax rates are for married filing jointly and the harshest tax rates are for married filing separately.
You may be able to file as Head of Household even if you were legally married on December 31st. To file as Head of Household, you must meet all these tests:
1. You were unmarried or considered unmarried on December 31. You are considered unmarried if your spouse did not live in your home during the last six months of the tax year.
2. You paid more than half the cost of keeping up a home for the year.
3. A child or other qualifying person lived with you in the home for more than half the year for whom you or the other parent is entitled to claim the tax exemption. (See Dependency Exemptions below)
Planning point. Couples 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. A word of caution if you are filing a joint tax return, the less financially knowledgeable party should review the tax return carefully to be certain there are no tax issues that he/she could be held responsible for in the future due to joint and several liability.
Dependency Exemptions
A dependency exemption, reduction in taxable income, of $3,700 (2011) and $3,800 (2012) is allowed for the taxpayer and each child/dependent. The issue of which parent is allowed the exemption is often addressed in the divorce decree. If not addressed in the divorce decree the custodial parent is allowed the exemption. The custodial parent is the parent with whom the child lived for the greater number of nights during the year.
Even if the custody of the child is determined in the divorce decree, the parents can trade the exemption back and forth by filing, with their tax return, Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent. A word of caution however, the custodial parent can revoke the election for the noncustodial parent. The revocation is effective in the tax year after notifying the noncustodial parent.
When there are multiple dependents divorcing parties often split the exemptions between them. This may not be the best tax strategy as the exemption can provide a better benefit to the higher income person.
Itemized or Standard Deduction
This tax issue concerns people that will be filing using the married filing separately status. Both tax returns need to be prepared using either the standard deduction or itemized deduction. This can be disadvantageous if one spouse has significant itemized deductions and the other does not. We will discuss later in this article a major source of itemized deductions, the primary residence.
However, a spouse who qualifies as unmarried (see above) and uses the head of household filing status does not lose the standard deduction if filing separately, even if the other spouse chooses to itemize. However the other spouse does lose the standard deduction if the spouse qualifying as unmarried and using the head of household filing status elects to itemize.
Child Care Credit
The parent who has custody of the children is entitled to claim a credit from 20% to 35% of the cost of work-related child care, up to a maximum credit of $1,050 for one child and $2,100 for two or more children under the age of 13. Unlike the exemption, the child care credit cannot be traded; it is available only to the custodial parent.
Alimony and Other Support Payments
The major difference between alimony and certain support payments is that alimony can be included in the taxable income of the recipient and is deductible by the payer. Support payments, such as child support, usually can not be included in income and therefore not deductible by the payer. So all other things being equal, payers want as much support as possible to be in the form of alimony, and recipients want as much support as possible to be in the form of child support.
There are exceptions in both circumstances. Payments made on behalf of a spouse for housing, medical payments, and debt relief, among other payments can be structured to be alimony payments, even though the spouse does not receive any cash.
Alimony means any payment in cash if:
1. it is received by (or on behalf of) a spouse under a divorce decree, a separate maintenance instrument, or a written separation agreement,
2. the instrument does not designate the payment as payment other than alimony,
3. the spouses are not members of the same household at the time the payment is made under the instrument,
4. there is no liability to make payments after the death of the payee spouse and there is no liability to make any payment as a substitute for such payments after the death of the payee spouse, and
5. the payments are not treated as child support.
Payments made to the spouse before the divorce is final and payments in excess of the amounts included in the divorce agreement are not considered alimony and therefore, are not deductible by the payer and cannot be included in income by the recipient.
Including the expenses of a jointly owned home as alimony can be further complicated by the type of ownership of the home. The following table indicates how much of your payment is alimony and how much may qualify as an itemized deduction.
Primary Residence
What to do with the primary residence is the second most contentious issue in a divorce after child custody. Transfer of one spouse’s interest in the primary residence to the other spouse does not generate any gain or loss. However, in many instances the primary residence may have to be sold.
Under current tax law, married filing jointly taxpayers can exclude up to $500,000 and single taxpayers can exclude up to $250,000 in gain on the sale of the personal residence, provided you meet the following tests.
1. You owned the home for at least 2 years (the ownership test)
2. You lived in your home as your main home for at least 2 years (the use test)
3. During the 2-year period ending on the date of sale, you did not exclude gain from the sale of another home.
The primary issue therefore is whether to sell the house before or after the divorce is final. The gain on the house is determined as follows: selling price less 1. expenses of the sale, 2. the original basis (typically cost) of the home, and 3. any improvements made to the home. If the gain is less than $250,000, than the issues related to the sale from a tax perspective are eliminated.
Selling the home before the divorce allows the parties to finalize the sale of typically the most significant asset and determine if there will be any taxable gain. It eliminates continuing upkeep of the property and it may free up cash that can be used by both parties.
Selling the home after the divorce has the opposite effect. Mortgage payments and property taxes need to be made and the home needs to be maintained. As indicated previously, the payments for these expenses can have an effect on alimony and support, depending on the divorce agreement.
The IRS has clarified the issue of determining the amount of gain exclusion for taxpayers that sell the house after the divorce by saying that you are considered to have used the property as your main home during any period when you owned it, and your spouse or former spouse is allowed to use it under a divorce or separation instrument. Therefore the ex-spouse that is not living in the home will still be able to meet the ownership and use tests. As such, make certain that the divorce instrument has specific wording on this issue.
Retirement Assets
The general rule is that the transfer of an individual’s interest in an individual retirement account or an individual retirement annuity to the spouse or former spouse under a divorce decree or under a written instrument incident to such divorce is not considered a taxable event. Many divorcing people however need to access the retirement funds for living expenses. Any distribution from a retirement account is subject to federal and state income taxes and may be subject to a 10% federal penalty if the recipient is under age 59 ½. However, there are several withdrawal methods that can be used to avoid the early withdrawal penalty.
• If withdrawals are made in substantially equal periodic payments, for a period of five years or until the recipient reaches the age of 59 ½, whichever period is longer, the early withdrawal penalty does not apply. The IRS has defined periodic payment as at least one payment a year and they have also provided three different methods for determining a substantially equal periodic payment.
• Similar to the substantially equal periodic payments method, is to make the distributions as an annuity. This option is only available for funds within Individual Retirement Accounts (IRA). The concern many people have about annuities is that the investment return is usually fixed and could be less than if the person had control over the assets.
• With most employer retirement plans, money cannot be removed from the account while the employee still works there. A Qualified Domestic Relations Order (QDRO) as part of a divorce settlement is one of the few exceptions. The tax code provides that money being transferred under a QDRO can go directly to the recipient spouse without being subject to the early withdrawal penalty. This is also true for distributions from and Individual Retirement Account (IRA) covered under a QDRO. The payment can also be split, with a portion of the funds being rolled into the ex-spouse’s IRA and the remainder being distributed, with none of the funds being subject to the early withdrawal penalty.
Planning point. All of the distributions not rolled over into an IRA are subject to income taxes, so it is important to review the effect of the distribution on your current and future year income taxes.
Other Property Transfers
Generally no gain or loss is recognized for property transferred to a spouse, or former spouse if incident to the divorce. The transfer is treated as a gift with the transferee having the transfer’s basis. There are exceptions to the general rule as follows:
1. The spouse or former spouse is a nonresident alien.
2. Transfers to a trust.
3. Certain stock redemption.
The following table provides some guidance on the tax treatment for certain transferred property.
Transfers of property are the most difficult tax area and both parties need to understand the consequences so please consult your tax adviser as soon as possible.
As you can see there are many tax issues that need to be addressed before finalizing any agreement. Please contact us if you need any assistance or have any questions.
About Blackman & Sloop CPAs, P.A.:
Blackman & Sloop is a full-service CPA firm headquartered in Chapel Hill, North Carolina and is actively involved in auditing, taxation, management consulting, financial planning, and related services. The firm directs a large part of its services toward providing management with advice on budgeting, forecasts, projections, financing decisions, financial analysis, and tax developments. The firm also performs review and compilation services and prepares not-for-profit, corporate, individual, estate, retirement plan, and trust tax returns as well as technology consulting services regarding installation and training on QuickBooks. Blackman & Sloop provides services in Raleigh, Durham, Chapel Hill, RTP, Hillsborough, Pittsboro, Charlotte, and the rest of North Carolina. To find out more please visit http://www.blackmansloop.com
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