Top Five Divorce FAQs During Tax Season

Divorce and Taxes. Blech.

Around this time of year, we typically get a bunch of questions from our divorce clients about what they’re supposed to do when they file their tax returns.

Here are our Top Five Divorce FAQ’s During Tax Season:

1.     Can I (should I) file separately?

A person's marital status for tax purposes is determined as of December 31st of the tax year. Therefore, if you are not holding a signed judgment of divorce by December 31, your options are to (1) file jointly with your spouse, (2) file as “married filing separately” or (3) as “head of household.”

Married filing separately is generally the least favorable filing status from a tax liability perspective. By contrast, filing Head of Household can offer significant tax benefits for eligible individuals. Whether you can file as “head of household” depends on whether you meet the qualifications under the Internal Revenue Code, including whether you and your spouse are living separately (see your favorite tax accountant or email us for specific details).

Whether you should file as “married filing separately” or as “head of household” is slightly more complex. First, will filing as Head of Household have an adverse tax impact on your spouse and will you need to account for that? Will it impact other tax credits and deductions, such as the Child Tax Credit or the mortgage interest deduction? The answers to many of these questions are often part of larger settlement negotiations in a divorce matter.

2.     Can I claim my child/ren as dependents?

Generally, child/ren can be claimed as dependents of the custodial parent who provides at least half of the child’s support. In joint custody situations, the parent with whom the child resides for the most nights in a year is considered the qualifying parent.

However, when parents have a valid stipulation or settlement agreement in place, the dependency exemption and child tax credit(s) are typically addressed by the agreement. Often, parties agree to alternate who will claim the child/ren in which years so that they can equally benefit from the available credits.

Note that child support payments are not tax-deductible for the payor and are not considered taxable income for the recipient.

3.     Are my spousal maintenance payments deductible?

No, not at the moment. Prior to 2019, spousal maintenance (aka, “alimony”) was tax deductible on the payor spouse’s income tax return and was included as income by the payee spouse. However, the tax code was amended and the current rules do not allow a tax deduction for the payor’s spousal maintenance payments and the payments are not included as income on the payee spouse’s return.

4.     How are assets taxed in a divorce?

Dividing assets in divorce is not a taxable event. No gain or loss is recognized on the transfer of assets in a divorce. However, sometimes assets must be liquidated in order for their value to be divided in a divorce, in which case, there can be an income tax consequence that must be considered.

Common assets in a divorce settlement include:

• Primary residences – Generally, married couples can exclude the first $500,000 of gains from the sale of their primary marital residence. If selling a marital residence is under consideration, it may be beneficial to sell the home before finalizing the divorce to maximize the exclusion amount and retain more proceeds from the sale.

• Retirement Assets – Qualified retirement plans (e.g. 401Ks) are divided pursuant to Qualified Domestic Relations Orders (“QDROs”), which are necessary to avoid a taxable event. IRAs are not qualified retirement plans and can be transferred to a non-titled spouse via a tax-free rollover. It is critical to understand the tax consequences on different retirement assets when structuring any settlement agreement, especially if one person’s interest in their spouse’s retirement asset is being traded for another asset type, such as the equity in a marital residence (i.e. those two assets are taxed differently and therefore are not “apples to apples” without adjusting for the disparity).

• Stock Options and Deferred Compensation - Transfers of interests in non-statutory stock options or non-qualified deferred compensation plans due to divorce are not taxable events. Income is reported when the former spouse exercises stock options or receives deferred compensation. This can be tricky if the former spouse is taxed at a higher tax bracket than the recipient spouse, and should be addressed in a well-negotiated settlement agreement.

5.     Do I qualify for innocent spouse relief?

Regardless of what the terms of a well drafted settlement agreement may say, if you file a joint tax return with your spouse, you will be jointly liable for the tax obligation. You can have terms in your settlement agreement that protect your right to be reimbursed by your spouse, but the IRS is not bound by your divorce settlement agreement. This often leaves unsuspecting spouses feeling vulnerable and looking for innocent spouse relief.

Generally, innocent spouse relief is available to all joint filers where one spouse had no actual knowledge or reason to know of a tax deficiency. The burden of proving actual knowledge is on the IRS, but the burden of proving that a taxpayer had a “reason to know” is much lower. Equitable relief is only afforded to filers who can provide that it would be unfair to hold them responsible for the nonpayment of the taxes due.

At Artese Zandri, we are dedicated to helping our clients navigate all aspects of family law, including the financial and tax implications of divorce. If you have questions, contact us at consultation@artesezandri.com for a complimentary consultation.