As we enter the shank of the year, our thoughts turn to Halloween, Thanksgiving, Winter Holidays, the New Year, and . . . taxes.  This is a good time to review essential divorce taxation.

Introduction

Divorcing couples often have to face a tangled web of chaos when dealing with their shared financial lives. This is particularly true of a marriage of long duration, in which assets and debts are often intertwined. When tax season comes around, a divorcing couple is likely to feel overwhelmed by the financial changes. Here are a few things to keep in mind when considering your post-divorce taxation and tax status.

Alimony and child support

When writing up your Settlement Agreement, understand that child support is not deductible for the payer or taxable to the payee, but alimony generally is both.  For alimony to be deductible, the agreement must state that it terminates upon death of the payee.  Almost always, remarriage of the financially dependent former spouse triggers termination of alimony, but that is not an IRS condition.  Parties can negotiate for lump sum alimony, which by agreement may be made non-deductible and non-taxable.  Parties often do this to create predictability, avoid long term dependence, and get rid of remarriage or cohabitation concerns.  Alimony that, by party agreement, terminates upon children reaching a certain age, may not pass the IRS sniff test, and the parties may be required to recast all the alimony as child support and reverse their tax positions (payor’s deduction is disallowed; payee’s tax payment is refunded).  The parties have to be careful with this one.

Transfer of property

When a couple divorces, they may transfer ownership of property and assets to one another without any tax implications. This might be significant if one spouse buys the other one out of a family home, and the home is eventually sold. This is something that should be written in to any agreement.  Trading pretax assets for post-tax assets is a bad idea, as they are not worth the same thing, even if the sticker price says they are.  Taxable assets once sold are subject to tax, which will no longer be shared with the non-titled spouse.  Therefore, great care must be taken in these circumstances as well.

Changing filing status

If your divorce is final by the 31st of December, you will file as either head of household (if you qualify) or single. Your status at the end of the year is retroactive for the entire year; it is not prorated for tax purposes.  Parties who remain married past the end of the year have the option of filing jointly or as married but filing separately.  Filing as a couple, even if a divorce complaint is filed, will save one or both of the parties a lot in taxes.  However, if you do not trust your spouse, and fear they have under-reported income, then you may decide to file in the more expensive “married but filing separately” mode.  Because if you sign tax returns that you believe are fraudulent, you may end up paying taxes, penalties, and interest when the fraud is discovered.  It is hard to take the benefit of a joint tax filing and then argue for “innocent spouse” status.  Spousal innocence is a possible outcome, but not a predictable one.  Often, but not always, parties who file joint tax returns while a divorce is pending pay their proportionate share of the taxes, as their respective incomes bear to the whole.  However, if there are refunds, these generally are split, on the theory that the joint filing saves both parties on taxes, so it literally pays to be generous with the refunds.  However, parties are free to do what they want; if they wish to agree to split the refunds proportionate to earnings, they surely may do so.

Claiming dependents

The primary custodial parent has the right to claim the children as dependents for tax reporting purposes.  However, this is not universally true.  Parties may negotiate taking children as exemptions.  If there are three children, then each parent takes one child yearly and rotates taking the third.  When there are only two children, they each take one.  When there is only one, each party takes the dependency exemption for the remaining child every second year.  However, in the case of high earners, where deductions taper off at certain levels of income and are eliminated once income is high enough, the other party will enjoy the dependency exemptions solely.

Conclusion

Your personal CPA or financial planner, in consultation with your family/divorce attorney, will advise you of your rights and obligations in this complex and mine-laden area of practice.  Family law professionals, your lawyer included, will listen to your facts, advise you about the law, and recommend the best course of action regarding your tax situation. Call the divorce and family lawyers at Hanan M. Isaacs, P. C., at 609-683-7400, or contact us online to arrange for a reduced fee initial consultation at our convenient Central Jersey law offices in Kingston, NJ.  You will be glad you did.