How to Avoid the Tax Traps of Divorce
There are certain implications that you should be concerned with if you are going through a divorce. Your tax circumstances are going to change and you should begin preparing for this as soon as possible. It’s recommended that you seek advice from a tax professional to help you evaluate your tax position and avoid making errors on your return.
The more advice and information you can obtain about taxes and divorce, the better off you’ll be. After all, the decisions that are made during the divorce proceedings will significantly affect your tax situation.
The following advice will help you avoid the tax traps of divorce:
Division of Assets
A divorcing couple must decide how to split up their assets. Instead of worrying about getting half of everything, you should first consider this advice:
Before a couple signs the divorce papers, they may transfer property tax-free (typically as part of a property settlement agreement). The ownership of major assets, including cars or houses, can be signed over or the property can be sold and the proceeds split.
The tax implications are more complicated if one partner buys out the other partner’s share of an appreciated property. The partner who retains ownership of that property should consider any taxes (e.g., capital gains) that may be owed once that property is eventually sold ? as a piece of advice, they should consider this before they agree to pay out half of the appreciated property’s value to the other partner.
If one spouse leaves the marital home (while their ex continues to live there), a proper agreement would allow that spouse to maintain a stake in the property but avoid owing taxes when the house is eventually sold. A good piece of divorce advice is to make sure that both parties receive an equal amount of assets that will and will not be taxed.
If a couple has a joint investment in a retirement plan (such as a 401k or IRA) and subsequently divorces, the plan can be divided to give each spouse their fair share. To do this without either spouse incurring a massive penalty for early withdrawal from the account, the couple will need to initiate a Qualified Domestic Relations Order (QDRO). The QDRO is good advice because it allows ownership in the plan to be transferred to an alternate payee, such as a former spouse or dependent child. Through a QDRO, property can be divided and alimony payments can be made.
Tax Filing Status
If you are considered legally divorced as of the last day of the calendar year, you must file as ‘single’ or ‘head of household.’ You may also claim one of these statuses if you are not divorced but you have a legally binding separation agreement, or if you and your spouse have lived apart for (at least) the last 6 months of the tax year.
If you are still legally married as of December 31st and were still living together, you must use the status of ‘married filing jointly’ or ‘married filing separately.’ If the spouses do not trust each other, it is recommended that they file separately. But if they decide to file jointly, they must understand that they are both responsible for the information on the return.
Depending on your specific situation, certain filing statuses may be more beneficial to you. As a bit of tax advice, ‘head of household’ and ‘married joint’ filers generally have lower taxes than ‘single’ and ‘married separate’ filers. So even if you are going through a divorce, you may try to file a joint return to save money and take advantage of this advice while you can.
Child Support and Alimony
Those who are going through a divorce must also make decisions when it comes to child support payments and alimony payments. In many cases, when two parents get a divorce, the non-custodial parent must pay child support to the custodial parent (or guardian), or to the government. In the case of joint custody, one custodial parent may pay child support to the other.
Since child support and alimony can affect an individual’s tax situation, divorcing couples should consider this advice:
- Child support payments cannot be included on (or deducted from) the tax return of the recipient, and they are not deductible to the parent paying them.
- Alimony ? which refers to an obligatory amount a spouse must pay for a previously dependent spouse, decided by a judge in divorce proceedings ? is considered taxable income for the recipient and an above-the-line tax deduction for the payer.
The parent who makes the child support payments is often the higher earner. They may, in fact, remit the money in the form of alimony in order to save on taxes. While the IRS does allow this, any alimony that resembles child support may not be fully deductible. It is important to understand the rules regarding divorce-related tax deductions before using this advice.
For more advice about filing your taxes during (or after) a divorce, consider hiring a tax professional.