Divorce and Taxes
When divorce and taxes affect a marriage many taxpayers going through divorce and separation issues must resolve many tax-related matters when they separate or divorce. Failing to consider these tax issues can have a long-term financial impact. Taxpayers contemplating separation or divorce are encouraged to consult with this office before finalizing any agreements.
When a separation or divorce occurs and the couple involved has one or more children, the noncustodial parent is usually ordered to pay some child support to the custodial parent. The child’s expenses over and above this sum are generally borne by the custodial parent.
Alimony is the term used for payments to a separated or ex-spouse as part of a divorce or separation agreement regarding taxes and the divorce. These payments are taxable to the recipient and deductible by the payer but are not treated as alimony if the spouses file a joint return with each other. Since 1985, two ways of defining alimony have been in effect, one for payments under decrees and agreements dated after 1984 and another for payments under decrees and agreements made before 1985. This article deals with only decrees and agreements after 1984 that alimony applies to new decrees and agreements.Divorce and Taxes have implications on both sides, especially if there are balances owed.
The following applies to alimony payments:
- Must be in cash, paid to the spouse, ex-spouse or a third party on behalf of a spouse or ex-spouse
- Must be required by a decree or instrument incident to divorce, a written separation agreement, or a support decree
- Cannot be designated as child support
- Is valid alimony only if the taxpayers live apart after the decree. Spouses who share the same household can’t qualify for alimony deductions. This is true even if the spouses live separately within the dwelling unit.
- Must end on the death of the payee.
- Cannot be contingent on the status of a child (that is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony).
Payments need not be for support of the ex-spouse or based on the marital relationship. They can even be payments for property rights as long as they meet the above requirements. Payments need not be periodic, but there are dollar limits and “recapture” provisions. Even if payments meet all the alimony requirements, the couple may designate in their agreement or decree that the payments are not alimony and that designation will be valid for tax purposes.
The recipient of alimony must include it in income for tax purposes. The payee is allowed to deduct the payments as an adjustment to gross income. The payee must also include both the name and social security number of the recipient that the IRS uses with the income reported by the recipient.
Spousal Buy-Out Debt
Generally, a taxpayers home mortgage interest is limited to the interest on acquisition debt and $100,000 of equity debt. In a divorce action sometimes one spouse will buy out the other. Often in these situations, the buying spouse will incur additional debt to buy out the other spouse. The IRS in notice 88-74 has stated that in this situation, the additional debt, secured by the home, to buy out other spouse will be treated as acquisition debt.
Community Property and Divorce
In community property states, community income must be divided between spouses as required by state law. In general, community income is that earned while spouses live together. Married taxpayers domiciled in the following states are subject to community property rules: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
Local law determines the definition of when a spouse begins receiving separate income. California law, for example, says separate income begins from the date of separation. Children and Divorce taxes
Community Property Rules Disregarded – Community property rules won’t apply to an item of community income, and a taxpayer has responsibility to report it if:
(B) The taxpayer doesn’t let his/her spouse know the nature and amount of the income by the extended due date of the tax return in question.
A taxpayer won’t be held responsible for reporting an item of community income if all of the following apply:
(1) The taxpayer doesn’t file a joint return,
(2) No item of community income is included on the separate return,
(3) The taxpayer didn’t know of the community income, and
(4) Based on the circumstances, it wouldn’t be fair for the taxpayer to include the community income on his/her return.
Transfers Incident to Divorce Property
No gain or loss is recognized when property is transferred between spouses during marriage. This rule applies also to transfers between former spouses if “incident to a divorce.” A transfer is considered incident to divorce if it occurs within one year after a marriage ends, or is related to the ending of a marriage (i.e., occurs within 6 years after a marriage ends and the transfer is made under a divorce or separation agreement). A transfer that occurs later than 6 years after a marriage ends can be considered incident to divorce if the taxpayer can show that legal factors prevented earlier transfer of the property.
The basis of the property received in a transfer between spouses or former spouses is the adjusted basis the transferring spouse had in the property. In effect, the recipient spouse has received a gift of the transferred property. If that asset is later sold for a taxable gain, the recipient taxpayer will be liable for the entire gain. This is an often-overlooked ramification of a transfer. As an example, the taxpayer has a bank account worth $10,000 and stock worth $10,000 that was originally acquired for $4,000. If one spouse took the $10,000 bank account and the other the stock, that would not be an equal split since the one that took the stock would be responsible for the taxes on the $6,000 gain in the stock.
Dependency Exception for Children of Divorced or Separated Parents
The following rules apply when determining which parent claims a child as a dependent where both parents together provide more than 50% of support, the child is in the custody of the parent(s) over half of the year, and the parents are divorced or legally separated under a written agreement, or lived apart at least the last six months of the year.
The basic rule is that the custodial parent defined as the parent with whom the child resides for the greater number of nights during the year claims the dependent. Note that divorce and family court rulings cannot trump federal law, and the only way the non-custodial parent can claim a child as a dependent is if they qualify under one of the exceptions below. When it comes to divorce and taxes you will need to consult with proper experts to explain all the options.
This is why it is so important to understand the tax implications associated with taxes and divorce divisions and transfer of property incident to divorce. If CLG Professional Services can be of assistance, please call 214-383-5690.