Divorce is far and away one of the most stressful ordeals two people can go through. Once a couple decides to part ways, many things come to mind: whether to sell the house, where the kids will go, who will take the pets, for instance. With such emotionally weighty matters at hand, tax concerns are often the last of each person’s concerns. Yet ignoring the tax implications of divorce is a grave error. Failure to adequately plan for life as a divorced taxpayer can get you into hot water with the IRS (which might make divorce seem bearable in comparison!)
Today, we explore some important tax implications of divorce – and how to deal with them:
Property settlement is likely to be the thorniest tax issue surrounding an upcoming divorce. The actual decisions regarding who gets what is not the tricky part – usually, each ex takes what the other one does not want, and what’s left of the couple’s total net worth gets split according to boilerplate ratios like 50/50 or 60/40. What makes property settlements a pain are the tax ramifications. Some assets (like a mortgage) involve tax liabilities or benefits while others involve none. Without special care, you could inadvertently agree to take something that sacks you with a gigantic tax bill.
To avoid these hassles, use the SmartMoney property settlement calculator which computes not just the fair market value of the possessions involved, but also the tax bill and the after-tax value of each item.
Child Support Payments
Contrary to what some divorced couples believe, child support payments are not deductible on your personal income tax return. This strikes many as unfair, since one could argue that the receiving parent is benefiting from unearned “income” in the amount of the payments. That said, do not attempt to deduct child support payments or deduct them under a different name (such as “family support”) as this is guaranteed to be rejected by any IRS employee who spots it.
Since child support is not tax deductible, your only choice is to pay it for as long as your decree states. Consult your decree if you are unsure of when or under what circumstances your child support obligations end.
Another pressing tax issue stemming from divorce (assuming you have children) is who gets tax benefits and exemptions pertaining to the kids. In a February 2010 article, SmartMoney notes that these exemptions ($3,650 per child in 2009 and 2010) generally go to the parent who wins custody of the children. Alternatively, parents can agree amongst themselves to override this rule and let the spouse of their choosing claim the exemptions instead. Nor will letting your ex take the child’s exemption prohibit you from claiming head of household filing status (more on that later.)
If your divorce was especially bitter, and your ex is the custodial parent, it is unlikely that they will agree to turn these exemptions over to you. In a more civil divorce, it is certainly a possibility. Just make sure that whomever claims the exemption files a copy of Form 8332 (Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent) each year. The custodial parent must also sign this form no matter what.
Alimony (spousal support) payments have unique tax considerations of their own. According to Lawyers.com, alimony payments are tax deductible for the ex who is paying them. If you are getting any clever ideas about disguising property settlement or child support money as alimony (and trying to deduct it) think again:
“If alimony appears to be “front-loaded,” which means that there was a concentrated payment within a very short period of time after the divorce, the IRS may consider the money to be property settlement funds (which are not deductible). Additionally, if alimony ends within six months of a child’s 18th or 21st birthday, this may trigger an investigation by the IRS to determine if the alimony is, in reality, disguised child support.”
To avoid doing this either intentionally or accidentally, consult an accountant regarding the amount and dispersal of any alimony payments you intend to make. Both spouses must also file separate tax returns as a prerequisite to alimony arrangements.
Head of Household Status
Which ex gets to claim head of household filing status on their income tax return is another contentious divorce-related tax issue. Heads of households, SmartMoney points out, are “entitled to more generous tax brackets and a bigger standard deduction.” Moreover, “various other tax rules are much more favorable for HOH filers than for singles.”
In order for the IRS to consider you “head of household,” you need to file your own separate tax return. Furthermore, you and your spouse cannot have lived together at any time during the last 6 months of the tax year in question. You also must have a “qualifying child” who lived with you for more than six months of the year even if this child can be claimed as a dependent on your spouse’s tax return. Letting TurboTax ask the right questions will help you determine the best filing status for you.