Tax planning and divorce sound like two unlikely partners, but they are not. This week’s blog post is written by Selwyn Gerber, CPA, who explains why tax planning is critical during and after a divorce.
There are significant planning opportunities available – and pitfalls for the unwary.
For those going through a divorce, tax planning may not be the most compelling issue to deal with – but whether you are structuring a property settlement, dividing retirement assets or filing income tax returns there are potential minefields to be navigated.
Alimony and child support.
Generally, spousal support is taxable to the person who receives it and deductible to the person who pays it, while child support is neither taxed nor deducted. However payments to an ex-spouse are not considered spousal support if not specified in the settlement agreement. Because there are no taxes withheld on spousal support received, frequently estimated taxes will need to be paid in during the year.
Filing status.
Couples who are separated (unless there is a legal separation or decree of separate maintenance in force) but not yet divorced before December 31 still have the option of filing a joint return because for tax purposes, if you are not legally divorced by year-end, you are treated as married. Only when the divorce decree becomes final is that no longer an option. Generally married-filing-jointly results in lower taxes than filing as married-filing-separately. However, joint liability attaches to that joint return. After your divorce is finalized, you can file as head-of-household (and get the benefit of a larger standard deduction and lower tax brackets) only if you had a dependent living with you for more than half the year and you paid for more than half of the upkeep for your home, even if you have relinquished the dependent’s exemption to your ex..
Tax exemptions for dependents.
You can claim your child as a dependent on your tax return if the divorce decree names you as the custodial parent. If the decree is silent, you would nevertheless be considered the custodial parent eligible for the exemption, if the child lived with you for a longer period of time during the year than with your ex. Generally, the parent who has the most custodial time with the children takes the exemption. But the settlement agreement can stipulate differently — for example that the Mother and Father alternate years for taking this deduction. If the non-custodial parent (i.e. the parent who spends less days with child) claims the children as dependents, at tax time, he or she will file Form 8332, a release of the exemption signed by the custodial parent stating that s/he won’t claim it.)
Note that the parent who claims the dependent exemption can also claim the child credit or an American Opportunity or Lifetime Learning college credit. Put differently, the parent who is not eligible to claim the exemption, cannot claim these credits … even if s/he paid the bills for college.
Medical expenses.
Children’s medical costs can be included in medical expense deductions of the paying parent regardless of who claims the dependency exemption.
Asset transfers.
When a divorce agreement allocates property between spouses, the recipient doesn’t pay tax on that transfer. However the property’s tax basis remains unchanged regardless of the actual market value at the time. When this property is sold, capital gains taxes will therefore be paid on the entire gain earned before as well as after the transfer. When dividing property, both tax basis and market value need to be considered, and the excess taxes that will ultimately be paid on sale should be taken into account. For example a $100,000 CD is worth more to the recipient than a $100,000 piece of raw land that has a basis of $50,000. There’s no tax on the CD, but when the land is sold for $100,000 or more, taxes will be paid on that $50,000 profit.
Home sales.
Generally the first $250,000 of gain on the sale of a primary home is free of tax if you have owned the home and lived there at least two years out of the last five. Married couples filing jointly can exclude up to $500,000 as long as either one has owned the residence and both used it as a primary home for at least two out of the last five years.
For sales after a divorce (assuming that the house remains jointly owned and wasn’t distributed to one spouse as part of the property settlement), if those two-year ownership-and-use tests are met, each spouse can exclude up to $250,000 of gain on their individual returns. The sale of a residence after divorce can qualify for a reduced ratable exclusion if the two-year tests have not been met, in certain specific circumstances beyond the scope of this article. The amount claimed depends on the proportion of the two-year period the home was owned and used. For example, if it was a year instead of two, each can exclude $125,000 of gain. However if you receive the house in the divorce settlement and sell it several years later a maximum of $250,000 can be excluded – and the time your spouse owned the home is added to your period of ownership for purposes of the two-year test.
Transfer of retirement assets.
A Qualified Domestic Relations Order (QDRO) allows retirement plan assets received from the paying spouse to be rolled into a retirement plan of the receiving spouse free of any current taxes. A QDRO is not required to transfer IRA funds, but the transfer must be specified in the divorce settlement. A violation of these rules will result in the transfers being treated as fully taxable in the year of withdrawal or transfer.
First-time home buyer credit.
If a home was purchased in 2008, 2009 or 2010 and a first-time home buyer credit was claimed, that tax break can be retroactively affected by the divorce. The credit must be repaid if, within three years of purchase, it ceases to be a primary residence. However if the residence is transferred to either of the spouses as part of the divorce, no repayment is due. Note that this potential tax burden attaches to the spouse who gets the home in the divorce.
Estate Planning
One of the first things to be taken care of when planning for divorce is to redo the estate planning documents. This should be quite apparent – and yet it is frequently overlooked. Keep in mind that beneficiaries of life insurance and retirement plans are determined by the beneficiary designations and not by the will / living trust. Accordingly, request and complete new beneficiary designation forms as part of the estate planning process. This should be a collaborative effort with your divorce attorney, as there are limitations put in place at the time a divorce is filed and fiduciary obligations are owed between spouses.
About the author: Selwyn Gerber, CPA is the founder of Gerber & Co., a full-service CPA firm (www.gerberco.com) and of RVW Investing, LLC Strategic Asset Managers (www.rvwinvesting.com). He can be heard frequently on the radio and is seen regularly on television. He is the author of the recently published book “The Wealth Blueprint”, a complete guide to portfolio design.