This article has been updated to reflect the Tax Cut and Jobs Act of 2017.
Divorce frequently has tax consequences. Here are ten important things to know when going through the divorce process. Depending on your situation, you may be able to implement strategies during the divorce to reduce taxes for one or both of you for years to come.
- Property Division Not Taxable. A property transfer related to divorce is not a taxable event pursuant to Internal Revenue Code Section 1041. This means that you do not have to pay taxes on assets that you receive in the divorce. This also means that you do not get to deduct the transfer of assets on your taxes.
- Spousal support. Beginning January 1, 2019 spousal support was/is no longer tax-deductible to the person paying it (the payor) or taxable to the recipient. However, divorces which were finalized prior to this date are ‘grandfathered in’ so that spousal support continues to be tax-deductible to the payor and taxable to the recipient. It’s important to address the issue correctly in any supplemental (modification) judgment so that the deductibility is preserved.
- Child Support. Child support is not a taxable event. The payor pays child support with after-tax dollars and the recipient does not have to pay taxes on the money received.
- Dependency Exemption/Child Tax Credit. The dependency exemption used to be a deduction from your taxable income associated with caring for a child. The dependency exemption no longer has any value in and of itself. However, it the person who claims the dependency exemption for a child also gets to claim the $2,000 child tax credit. A ‘tax credit’ is a dollar-for-dollar reduction off of your taxes, where as a tax-deduction just reduces the amount of income you pay taxes on. If you do not specify who gets to claim the child, then the IRS rules say that whoever spends more than half of overnights with the child gets to claim that child. If you have a 50/50 parenting plan, the IRS says that whoever has the higher income gets to claim the child. These are just the default rules – you are allowed to “trade” the dependency exemption and child tax credit. For example, if you have one child, it is possible to agree that you will each claim the child every other year. If you have two children, it is possible to agree that you will each claim one of them. It is important to note that the tax benefit associated with claiming the dependency exemption and child tax credit is phased out at very high income levels.
- Capital Gains. When you are dividing stocks or mutual funds that are NOT held in retirement accounts, you need to be aware that you may have to pay taxes on those stocks when you sell them. For example, let’s say you have ten shares of Google stock that are worth $500 and you paid $100 for five of them and $450 for five of them. If you sold the shares tomorrow you will pay capital gains on $400 of gain for the shares that were purchased for $100 but only pay capital gains on $50 of gain for the shares that were purchased for $450. This is true even though all of the shares are worth $500! Therefore it is very important to know what the “basis” (purchase price) is when you are dividing assets to which capital gains may apply. Capital gains can also apply to other assets, not just stocks. It is important to know that assets that are held for less than one year are taxed at normal income tax rates, while assets that are held for more than year are taxed at a more favorable long term capital gains rate (0% or 15% for most people). Depending on how you structure a settlement, you may be able to save on taxes thanks to the capital gains rules.
- Retirement Transfers. You can divide a 401(k) and certain other types of retirement accounts without incurring penalty or paying income taxes using a Qualified Domestic Relations Order (QDRO). If you did not use a QDRO and just cashed in a portion of the retirement to give to your ex, you would incur a 10% penalty (if you are under 59.5) and pay income taxes based on the account owner’s tax bracket. A QDRO allows you to make the transfer without tax or penalty; the amount awarded to your ex will be transferred into a retirement account in his or her own name (usually a rollover IRA). Your divorce judgment will specify how much will be transferred. The QDRO is a supplemental legal process that happens after the judgment is signed by the judge (or at the same time). QDROs are a specialized area of the law and most divorce attorneys do not draft them. However, your divorce attorney or mediator should be able to provide you referrals to one or more QDRO attorneys.
- IRA Transfer. IRAs can be transferred without a QDRO when done pursuant to a divorce judgment. The company that holds the IRA will have a form that you need to fill out and you will likely have to provide a copy of the judgment when you initiate the transfer. IRA transfers are free and relatively quick; QDROs usually cost $500 or more and can take up to several months to complete. If you have both IRAs and 401(k)s, one strategy is to do the entire transfer from the IRA so you can avoid having to do a QDRO.
- Head of Household. If you have more than 50% of overnights with a child then you can file your taxes “head of household”. Head of household is a more favorable tax filing status and results in having to pay less tax. Unlike the dependency exemption, you cannot “trade” head of household tax filing status. In other words, you can only file head of household if your child actually spends more than half of the year at your house. If you have a 50/50 parenting plan and two kids, one strategy is for each parent to get an extra weekend with one of the children so that both parents can file head of household.
- No Partial Year Filing. If you are married as of December 31st you can file taxes as “married filing jointly” or “married filing separately”. If you are divorced on or before December 31st you have to file “single” or “head of household” (if applicable). It is not possible to file part of the year as a married couple and part of the year as single. One common strategy toward the end of the year is to wait to finalize your divorce until January so that you can file jointly for the prior year.
- Capital Losses. Don’t forget to address carry-forward capital losses in your divorce judgment. If you have previously filed jointly, look at your most recent tax return to see if you have capital losses that you can carry forward to the following year. If you do, these can be divided between the two of you. Depending on your situation, it may make sense to award the losses to someone who is also receiving an asset that has capital gains associated with it. A different strategy would be to award the losses to a person in the higher tax bracket.
Lastly, lawyers not CPAs! You should not rely on your lawyer for tax advice unless they happen to be a tax lawyer or also happen to be a CPA. Lastly, this article is provided for general information only and should not be construed as tax advice. If you need tax advice you should consult with a licensed tax professional.