Stephen T. Sadler, JD, LLM
Managing Director & Senior Financial Counselor
November 14, 2016
Do you have a family member or friend who is contemplating divorce? Putting all emotions aside, the legal aspect of divorce is essentially a business transaction involving the division of assets between partners. Unfortunately, it is also an emotional division of the partnership, and what once seemed fair and reasonable can now be viewed as vindictive and overreaching. While many spouses seek an amicable parting of the ways, in divorce, every decision that is made will negatively impact someone (except, perhaps, the attorneys). In addition to the emotional tumult, divorce entails complicated and consequential financial issues that can have long-lasting effects on both parties. Understanding the financial issues involved in a divorce can save thousands of dollars in unnecessary tax payments. Below is a brief overview of some of the most common tax issues associated with divorce.
Alimony is support paid by one spouse to a former spouse under a separation agreement. Alimony is taxable income to the recipient and an above the line tax deduction for the payor. Distinguish this from child support. Child support is paid from one spouse to the other for the benefit of child(ren) and is neither taxable income nor tax deductible. Clearly there is a tension here between the payor’s desire to have tax deductible payments and the recipients desire to minimize taxable income.
Filing status is determined by the party’s marital status as December 31st of the tax year. If a divorce decree is not yet final, the divorcing couple can file a joint return (which provides preferential tax rates) or married filing separately. Once the divorce is complete, each of the parties can file as single (least favorable tax rates); or, if there are dependents living with them for more than ½ year and they provide more than ½ their support, then they can file as head-of- household (more favorable tax rates). The divorcing parties should prepare a tax projection to understand the most tax efficient filing status for each of them.
Children can be claimed on a parent’s tax return if the court decree names that parent as the custodial parent. A custodial parent can waive their right to claim the exemption, and this would occur in cases where the dependent exemption would provide little or no tax benefit to the custodial parent. The parent that claims the exemption also has the right to claim the child tax credit and educational tax credits regardless of which parent actually pays the tuition. But note that, on the contrary, a child’s medical expenses can be deducted by the payor regardless of which parent claims the child as a dependent.
Most divorces involve the disposition of the marital home. Married couples filing a joint return are provided a $500,000 capital gain exclusion amount on the sale of their principal residence if they resided in the property for at least two out of the last five years. While the transfer of the principal residence from one spouse to another is not a taxable transfer, the post-divorce party owning the principal residence will only be eligible for the single exclusion amount of $250,000.
Under Internal Revenue Code Section 1041, transfers between spouses are tax free. Likewise, transfers between former spouses that are “incident to a divorce” are also tax free. In order for the transfer to be incident to a divorce, the transfer must relate to the “cessation of the marriage”. In addition, transfers made later than one year from the end of marriage must be incorporated into and made pursuant to a legal separation agreement. Note also that not all assets are tax equal. Assets carry with them their imbedded tax basis. Cash of $100,000 is worth more than a brokerage account worth $100,000 that contains stock with a $50,000 basis. When the stock is sold, a capital gains tax will be due. A proper division or assets should also include an after-tax analysis.
Qualified Plan Assets
Special attention is required to the division of qualified retirement plan assets such as pensions and 401(k) plans. If a separation agreement does not contain a “Qualified Domestic Relations Order” (QDRO) specifically referencing the retirement plan, then the non-employee spouse may not be entitled to any share of the retirement plan benefits. The division of retirement assets without a QDRO also has huge negative tax potential. For example, if the parties decided to divide a 401(k) plan equally between them without a QDRO in place, then this would be deemed a taxable distribution of one half of the 401(k) plan assets subject to income tax in the year of the division. You don’t need a QDRO to divide IRA funds, but the transfer(s) need to be made pursuant to a divorce decree or written instrument incorporated into the court order.
A divorce can be complicated, and the above issues are just a handful of what a divorcing couple may face. Each situation is unique; and because divorce is also regulated by state law, tax issues involving potential state differences must be addressed. During such a difficult transition in one’s journey, having good counsel to provide needed guidance can help avoid any long-term negative financial consequences and allow the parties to focus on other matters such as emotional and family well-being.