Tax Issues when You Get Divorced

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When a couple divorces or separates, there are many issues that need to be sorted out. One issue many forget to discuss is taxes. Here is a look at some of the tax issues divorcing couples may encounter.

File Jointly or Separately?

For tax purposes, a person’s marital status is determined on the last day of the tax year, so individuals who separate (but don’t divorce) during the year typically will need to make a choice between filing jointly or separately.

Filing separately may result in the loss of valuable tax credits and deductions. For example, the American Opportunity Tax Credit (for higher education costs) is not available to a married taxpayer who files a separate return. Typically, filing jointly will result in the lowest overall tax.

One reason to consider filing separately is for protection from the other spouse’s future tax liabilities. Generally, spouses who sign joint returns have joint and several liability — meaning that they are each fully liable for unpaid tax liabilities arising out of the return. Moreover, the IRS has the right to pursue the party who is best able to pay the full amount quickly, leaving issues of fairness to be worked out between the two filers. (The “innocent spouse” rules and/or the “separate liability” election may provide protection in some circumstances.)

Alimony Versus Child Support

Alimony represents taxable income to the recipient and a tax deduction for the person paying it. Child support, on the other hand, is not taxed to the recipient, and the person paying the child support gets no deduction for the payments. Because the tax consequences are so significant, a number of technical rules govern what constitutes alimony.

Generally, alimony must be paid in cash (or by check) pursuant to a divorce or separation agreement and terminate upon the death of the recipient. Some people — in the divorce decree or settlement agreement — try to “front-load” their alimony payments by designating payments in the early years as alimony rather than as child support. The IRS has specific rules limiting front-loading.

Property Transfers

Spouses should take care when dividing up assets. The general rule is that no gain or loss is recognized for property transfers if they occur either within one year of the end of the marriage or within six years of the end of the marriage and pursuant to a divorce or separation instrument. However, such transfers may create tax issues down the road, because when the property is sold, the owner may have to pay capital gains tax on the difference between the sale price and the basis (generally, the original cost). As a result, it’s important to consider potential future taxes when negotiating a property settlement.

Child-related Tax Breaks

Only one parent may claim the dependency exemption for a child. Generally, the dependency exemption will go to the parent with physical custody, although numerous subsidiary rules may apply. The rules for claiming the child tax credit generally track those for the dependency exemption. And the general rule for the child and dependent care credit is that the credit will go to the parent with physical custody.

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