Every divorce situation is different and therefore so are the tax consequences. This is an overview look at some of the basic tax consequences in a divorce and what you should be aware of for your finances if you are considering a divorce. Some items you’ll feel relief at knowing you don’t need to pay any tax, others may leave you feeling disgruntled that you are not entitled to a deduction on them. Regardless, being knowledgeable about what these financial components mean for you will make things much easier as you proceed. Here are the 9 biggest divorce taxes and consequences to be aware of.
1. Asset Division
As a general rule, assets that are transferred as part of a divorce settlement result in no tax consequences on that transfer. Another way to state that: property settlements are nontaxable events. So, if husband must transfer $200,000 from his 401(K) account to his wife, there is no tax on that transfer of $200,000. However, when the wife takes a withdrawal from the 401(k), she will incur a tax liability.
2. 2018 Changes to Alimony
For divorce orders and separation agreements executed after 2018, alimony is no longer deductible by the payor spouse and is no longer taxable income to the receiving spouse. This was a major divorce tax law revision in 2017. However, if your divorce agreement was executed prior to 2018, you may follow the old law meaning alimony is deductible by the payor and remains taxable to the recipient. You can read more about alimony tax consequences here.
3. Child Support
Child support is not taxable to the receiving parent; child support is not deductible for the paying parent. As of 2018, this makes child support’s tax status identical to alimony, as detailed above. Child support is mandated by the state based on factors like income, time spent with the children, and childcare payments. You can read more about child support and taxes here.
4. Child Dependency Exemption
Tax law governs who gets the child dependency exemption; it is the spouse with legal custody. If the parties agree otherwise, the parties need to comply and see that the proper IRS form, 8332, is signed. A well draft separation agreement should address this and the required cooperation needed.
5. Selling Your Home
A couple can generally exclude up to $500,000 of gain from the sale of their primary residence. For sales beyond $500,000, you may be subject to tax payments.
6. Joint Filing Status
A separated couple can still file jointly if they are still married on December 31 of that tax year. Thus, scheduling by whom and when an action for divorce is filed, may mandate some cooperation and planning. If a couple does file jointly, each person can be made to pay 100% of the taxes owed.
7. Individual Filing Statuses
Generally, if each spouse files a separate return, that tax rate will be higher compared to a joint return filed by the parties. You must file independently starting in the year that your divorce decree is granted. If you are still legally married, you have the option to file as married filing separately but keep in mind that the tax rate will still be higher. This option is best for couples who are not yet officially divorced but who are separated from each other with separate property and do not have easy access for communication with each other.
8. Legal Fees
Spouses cannot deduct divorce related legal fees nor court costs on a tax return. Make sure you take this into account when calculating your court related costs, as this applies across the board.
9. Audits
If there is an audit and back taxes are owed or there is a tax liability, one spouse can apply to receive innocent spouse designation. However, this relief is not automatic. In 2021, over 26,000 US taxpayers applied for this protection; less than 5000 applications were approved. This is often an issue for spouses of the self-employed.
A good divorce lawyer will tell a client to consult with his CPA about income tax or divorce taxes and consequences. Likewise, a good CPA and tax preparer will encourage a client to seek advice with his divorce lawyer regarding the legal consequences of divorce.
Make sure proper professional advice is sought. Laws, especially tax laws including laws concerning divorce taxes, never remain the same; they are always changing. Accurate and current advice is always required .
