Taxes impact nearly every aspect of life and divorce is no exception. Yet, many couples become consumed with emotion during divorce and fail to recognize the tax implications of their settlement decisions.
If you are considering or are in the process of a divorce, you may be able to minimize your total tax liability by working with a divorce financial analyst and/or tax accountant on how your settlement is structured. Failure to take into account the tax consequences of how you structure your settlement could turn what appears to be a fair and equitable agreement into a financial disaster. The settlement agreement has to be calculated based on divorce law and IRS rules, and carefully worded in the divorce decree. The goal should be an overall reduction in taxes paid by both spouses, resulting in the greatest after-tax cash flow.
Here are some general rules to be aware of:
One is considered “married” for tax purposes if the divorce is not final by December 31 of the tax year in question. For example, whether your divorce is final on 1/1/15, or 12/31/15, you will be considered to be “unmarried” for all of 2015 by the IRS.
The typical rule for spouses filing separate returns is for each to report half of any community income and claim credit for half the income tax withheld. But a person is not responsible for the tax on community income if: 1) there is no joint return for the year, or, 2) the community income was earned by the other spouse and isn’t included on the separate return. (Special rules exist for those living apart for the entire tax year and are not detailed here.)
When filing separately, estimated payments made jointly can be divided by agreement between spouses. If a couple cannot come to an agreement, the IRS will divide the payments proportionally based on each spouse’s income reported on their returns.
Similarly, the carry forward credit for overpayments from previous years will be allocated by the IRS based on the parties’ proportional income in the current year.
We frequently see a spouse underestimate income in an ill-conceived effort to reduce his or her exposure to an unfavorable property award. This can result in underpaid taxes, interest and penalties. Because both spouses are jointly liable for all taxes on a joint return, a spouse may become liable for the other spouse’s tax liability.
Itemizing deductions during pending divorce
Generally speaking, when the spouses file tax returns with the IRS as “married but separate” while their divorce is pending, the spouse who pays for a particular item gets to claim the deduction for the payment. Where a home is titled in both names, the spouse making the mortgage or tax payments gets to claim the associated deductions.
An exception is sometimes made when the asset receiving the payment is specifically tied to one spouse. For example, contributions to an IRA are deductible to the spouse owning the IRA regardless of which spouse made the contributions.
Or, where a house is titled and the mortgage is in the name of one spouse only, the tax payments and interest payments may not be claimed as deductions by the non-owning spouse, regardless of who made the payments.
Gains from the sale of the home
A couple may exclude from income up to $500,000 of gain on the sale of their home, assuming they lived there for two of preceding five years. If one spouse receives the home in the divorce, he or she could end up with a large capital gains liability. If there is a $300,000 gain, the $250,000 shelters all but $50,000, resulting in a capital gains tax of $7,500 to $10,000. This should be included in the calculations of the final settlement and offset with assets.
Estate Planning Considerations
In addition to the above, I advise clients to consider making changes during the divorce process to ensure that the current spouse is removed as power of attorney, trustee or beneficiary of IRAs, qualified plans, non-qualified plans or life insurance policies.
Join Patricia Barrett at her upcoming 2015 Houston Leisure Learning classes on March 16 from 6:30 – 9:30 p.m. She is a regular instructor for Manousso Advanced Family & Divorce Mediation training, given quarterly. She will also be presenting at the Guide to Good Divorce seminars in Houston on Feb. 28, May 16, July 18 and Sept. 26 at the Houstonian Hotel, Club & Spa. For more information on divorce financial planning or divorce mediation, visit Patricia’s website, Lifetime Planning.
This article is designed to provide readers with a general overview of the issues discussed.