If you're reeling a bit from filing tax returns a few weeks ago, that's certainly not an unusual feeling -- even for those of us who are lucky enough to get money back. But for those in the process of getting divorced, filing tax returns this year can bring up questions and anxiety as they transition from married taxpayers to newly-single-again taxpayers.
My colleague David Droppo recently contributed an article to the blog I help oversee for the Collaborative Law Institute of Texas, anticipating questions and attempting to alleviate anxiety over divorce and tax issues, and there are a number of valuable points he made in that article I feel are worth sharing.
Here's a quick overview of what you should know.
1. Know your filing status:
Filing status determines which tax rates apply to you, what you owe in taxes, and what deductions and credits are available. You can either file as single, married filing jointly, married filing separately, head of household, or qualifying widow(er) with dependent child. In general, your filing status is determined by legal status on the last day of the year. If you are single on December 31, then for tax purposes, you may be considered single for the entire year.
It may be to your advantage to plan the timing of your filing status, assuming you have the luxury of doing so. If you qualify for more than one filing status applies, you should choose the one with the lowest amount of taxes attached to it.
During a divorce, spouses may wish to continue filing jointly for as long as possible. While filing jointly enjoys advantages over other filing statuses -- taxes may be lower, standard deductions may be higher, and other tax benefits may apply - also be aware that there can be disadvantages. Much the same way as you have rights to a tax refund, the other spouse's debts and liabilities will be attached to the taxes. For example, a joint return may obligate both spouses to be jointly and severally liable for any error on the tax return.
2. Know how to divide the pile:
Though dividing assets and debts is the big ticket item, you also need to factor in tax-related issues concerning income and deductions. Jointly held assets can create income in the form of dividends and interest. In addition, there are deductions from real estate taxes, mortgage interest, medical cost deductions, and loss carry-forwards that you'll need to allocate as you're figuring out your divorce.
A retirement plan is also considered a form of property in divorce. You should understand what a qualified domestic relations order (QDRO) is and whether it applies to your retirement plan, and you should also know the tax ramifications when retirement plans are divided after the divorce.
3. Know what alimony is:
Alimony is a payment made to a former spouse pursuant to a divorce decree to help maintain his or her lifestyle. Payments are deductible by the payer and included in the recipient's income. To be considered alimony for tax purposes, it must meet certain requirements; IRS Publication 504 is a helpful resource for this. Child support is viewed differently in that payments are not deductible by the payer, and are received tax-free by the recipient.
4. Know rules around exemptions:
One of the most important decisions you'll make regarding divorce and taxes, if you have kids, involves the assignment of dependency exemptions. You should understand each parent's rights to these exemptions, how to transfer those rights, and what's required to eligible for those rights.
5. Know rules around property settlements:
When spouses decide how to split their property, taxes obviously factor in. In many cases, couples draw up an agreement assigning assets and debts. The tax effects of property division vary greatly depending on whether you decided to transfer to a spouse, sell the property, and the timing of each decision. Generally speaking, there is no gain or loss recognized for property transferred to a spouse or former spouse, pursuant to a divorce. If the transfer occurs incident to the divorce and within one year or the marriage ending, it may be considered a gift.
A common consideration is selling what is often the largest asset, the marital home. If certain requirements are met, the Internal Revenue Code allows that up to $500,000 of gains can be excluded from the sale if both spouses file jointly. The exclusion is reduced to $250,000 for single filers. Therefore, if a large gain exists, then selling while still married provides a greater tax savings.
The rules around what you should know illustrate something obvious about divorce - issues like determining who gets which dependents for filing purposes and dividing rights to assets and property can be obviously difficult. As an advocate for collaborative law, I believe that a collaborative team provides advantages and create a best-fit solution that maximizes tax savings for both spouses. Those in a traditional divorce situation still need to be mindful of all these issues and how they can be reconciled, with an eye toward recognizing fair and equitable solutions as determined through negotiation or whatever a judge might determine.