Divorce is never a pleasant topic unless you’re a family law attorney. And paying extra taxes because you didn’t get good or timely advice adds insult to injury.
Here are some points to consider before you start divvying up the silverware:
Spousal support: Alimony is deductible to the payer and taxable to the recipient, which can create a nice tax arbitrage when the spouses are in separate tax brackets. It also counts as “earned income”, for purposes of contributing to an IRA. Both spouses will have to report the Social Security Number of the recipient for IRS matching. To be considered alimony, and therefore deductible, payments must meet 7 requirements imposed by the IRS. Child support is neither deductible nor taxable.
Cost of divorcing: Legal and accounting fees are deductible if related to the production or collection of income. Ask your CPA and attorney to itemize their invoices to specify the amounts that qualify. However, you are limited to deducting only the amount in excess of 2% of your Adjusted Gross Income. This includes other deductions subject to the 2% limitation, such as employee business expenses.
Timing: Your marital status on the last day of the year will determine your filing status, not how long you were married during the year (with one exception at the end of this section). If you are divorcing near year’s end, check with your CPA to see if you will be better or worse off by waiting until January 2. The larger the income discrepancy between the 2 of you, the more likely filing jointly will benefit you.
The exception to the marital status rule that the IRS allows is if you are legally separated under state law. Seven states do not recognize legal separation, however, and the IRS honors the divorce laws at the state level.
Exemptions: If you have at least two children and you are choosing who will claim which child on your tax returns, you’ll have longer to claim credits for the younger child(ren). If you are claiming children on alternate years and your ex claims them when (s)he is not allowed to do so, it will take a little correspondence to get everything straightened out with the IRS. In the meantime, any refund will be delayed. The best way to avoid this is to file before your ex files.
Because exemptions are phased out at higher income levels and are not very useful at lower levels, your CPA can help you calculate the tax benefits for each spouse to determine fair allocations.
Separate or joint: If you are concerned that your soon-to-be-ex-spouse may not be reporting income, insist on filing married, but separate. Your signature on the joint return makes you jointly liable for the taxes and penalties, including any later discoveries. You can always amend to Married Filing Jointly within the next 3 years if it will make a difference, but the IRS will not let you amend MFJ to MFS for that very reason.
Social Security records: Be sure to change to your maiden name with the SSA before beginning to use it for payroll records. Not doing so could mean your earnings are not reported correctly to the SSA for purposes of calculating Social Security or disability benefits.
Carryovers, etc.: Be sure to account for the division of any “phantom” (non-liquid) tax attributes. The tax code determines some splits but even those calculations are debatable when you share property, investments, and businesses. It’s best to get them in writing in the divorce decree or property settlement. Examples are:
- Capital loss carryovers both long-term and short-term: Capital loss carryover deductions are limited to $3,000 per couple per year. Couples who are MFS must split the deduction ($1,500 each). But, post-divorce, you go back to $3,000 in capital losses per person per year.
- Passive Activity Loss (PAL) carryovers: there are special rules if a jointly-owned property to which a PAL attaches is kept by one spouse rather than being divided.
- Suspended losses from S-corporations: suspended losses remain with the owner of the stock. If jointly-owned stock is transferred to one spouse, the proportionate amount of loss carryover attaching to the stock of the relinquishing spouse is lost.
- Income tax refunds related to your marriage but not yet received
- Net operating loss (NOL) carryovers, either business or personal
- Estimated tax payments you have already made
- Taxes due for any part of a year in which you are married
- Mortgage interest and real estate taxes paid before the divorce is final. By the way, not only can couples deduct mortgage interest on the first $1.1M of mortgage debt, but the full $1.1M debt amount extends to singles, too.
Property divisions: Most transfers of property from one spouse to the other “incident to divorce” are treated as gifts and not taxed. Further discussion is beyond the scope of this article.
Remember that state laws will also affect your taxes when divorcing. So will living in a community property state versus a common law state.
Retirement accounts are often the most valuable asset in divorces. This month’s Fiscal Fitness video lays out the ground rules for retirement accounts you have accumulated during your marriage.