During your divorce, you may be faced with various tax issues and it is important that you understand these divorce tax implications before negotiating your final settlement. If issues are discovered in your taxes after a divorce settlement has already been negotiated, resolving them post-settlement can add substantially to the cost of your divorce. Your divorce attorney can help you spot potential problems during the divorce, but tax advice is not something they're qualified to offer.
To obtain sound advice on how to handle divorce tax issues, it is important that you consult with a qualified expert, such as a certified public accountant or tax attorney, who is knowledgeable on the subject.
Here are some common divorce tax questions and situations that you should discuss with a qualified tax professional prior to reaching a final divorce settlement.
- Divorce can trigger costly tax surprises. Miss them before settlement and you could pay long after the decree is final.
- Key issues include shared liability for past returns, filing options in the year of divorce and who claims children, refunds and deductions.
- Alimony is no longer deductible or taxable. Retirement accounts, investment gains and loss carry-forwards can quietly change real value.
- Clear tax planning can save time and money.
Tax Return Filings for Each Year of Marriage
In a standard final divorce decree, the typical agreement is that for each year of the marriage, both parties share equal responsibility for any federal income tax liabilities and are each entitled to half of any federal income tax refunds accrued during those years. If you are wondering, am I entitled to half of the tax return? This provision explains why.
However, this "typical" agreement does not work for everyone. It's essential to determine whether you filed a federal income tax return for every year of your marriage, if you were audited during those years and if you have any outstanding tax liabilities for any year of your marriage.
Obtaining Copies of Past Tax Returns
We recommend securing copies of all federal income tax returns from each year of your marriage for at least the last seven years. If one spouse is a business owner or has complex investments, such as real estate, the likelihood of an audit could be greater than it is for a typical W-2 worker and it’s possible the IRS might find that you and your spouse owe taxes after divorce for a previous year of marriage.
Before agreeing to the "typical" arrangement, discuss with your tax advisor the potential for being audited and the possibility of incurring tax liabilities for previous years.
Filing Your Tax Return for the Year of Divorce
For the year you officially divorce, you and your ex-spouse will file separate returns, since your marriage status is determined by what it is on the last day of the year.
Options for Filing
In Texas, you have two options for dealing with taxes during divorce for the months you are married:
- Option 1: Partition income for the entire year, filing as if unmarried and claiming only your deductions, withholding and income.
- Option 2: Claim half of your spouse's deductions, withholding and income for the months you were married, while your spouse claims half of yours.
Pros and Cons of Filing Options
There are pros and cons to each. The simplest method with the least coordination with your ex-spouse is to partition income. However, financially, this may not be optimal. Consult your tax professional to understand the consequences and determine the most appropriate method. How you file your federal income tax return for the year of divorce MUST be set out in your divorce settlement.
If your divorce decree does not explicitly state that you are partitioning income, your taxes should be filed using the second option by default, according to the IRS. Additionally, you may be eligible for deductions such as mortgage interest, property taxes or charitable contributions accrued during the portion of the year you were married. These should be addressed in your divorce settlement.
Child-Related Deductions, Exemptions and Head of Household Status
Under IRS guidelines, a parent can claim head of household status based on the number of nights the child spends in their custody. Regulations also determine which parent is eligible for child-related deductions and exemptions. It's crucial to understand these rules before entering divorce settlement negotiations.
Contractual Agreements for Deductions
Parents may also contractually agree on who claims these deductions, which can serve as a bargaining tool in negotiations. Consult your tax professional to understand the impact of these deductions and exemptions post-divorce.
Alimony and Spousal Maintenance
Alimony or spousal maintenance is a set amount paid monthly for a predetermined time post-divorce. Under current federal tax laws, alimony or spousal maintenance is non-taxable and the payer does not receive a deduction. Payments are made with after-tax dollars, similar to child support.
Tax Loss Carry-Forwards
A tax loss carry-forward occurs when a taxpayer reports a loss on their tax return up to seven years after it occurred. This can reduce tax liability in a high-income year. Any unreported losses may become an asset to divide during your divorce.
Consult your CPA to determine if tax loss carry-forwards exist and how to allocate them in your divorce settlement.
Retirement Accounts and Tax Consequences
During divorce, withdrawals from retirement accounts may create federal tax liability. Your CPA should calculate any taxes associated with early withdrawals.
Additionally, one party may receive a portion of the other's qualified or non-qualified retirement accounts. These funds may be liquidated without penalty but are subject to federal taxes. Understanding the tax plan and divorce implications is crucial for post-divorce planning.
When evaluating retirement accounts, consider that contributions were made with pre-tax dollars. This impacts the true value of assets in your divorce negotiation. Forecasting taxes at retirement can provide a clearer picture of your estate and assist in fair division.
Other Tax Considerations in Divorce
Here are key tax issues to consider when negotiating your divorce settlement:
Quarterly Tax Payments
Taxes can get more complex if one of you isn’t a typical W-2 employee. Many taxpayers, such as self-employed persons or members of a partnership, are required to make quarterly tax payments directly to the IRS instead of their employer withholding taxes from a paycheck.
This raises a common question: do I have to claim divorce settlement on taxes? The answer depends on how your divorce settlement allocates assets, deductions and income. Knowing what is taxable and what isn’t can help avoid unexpected liabilities. This means that four times each year, the taxpayer sends the IRS an estimated tax payment for that quarter.
In negotiating a divorce settlement, it is important to know how much your spouse has paid to the IRS in quarterly tax payments to date for the current year and prior year. If a portion of these payments exceeded the actual liability for the tax year, they could be an asset of the community estate.
Investment Accounts and Capital Gains
Before negotiating your divorce settlement, examine the actual investments (stocks and bonds) in any brokerage or investment accounts to determine an estimate of the cost basis of those investments. Some stocks may have had a large appreciation in value and therefore, upon liquidation, you will pay short-term or long-term capital gains tax on the stock appreciation. You should consider the tax implications of those investments in light of your intended use of those funds.
For example, if your goal is to liquidate funds to purchase a home, then agreeing to be awarded a brokerage account with large amounts of capital gains tax liability upon liquidation in lieu of requiring your spouse to do a refinance of the marital residence and pay you cash may not be in your best interest.
Final Thoughts on Taxes in Divorce
As you can see, taxes impact virtually every decision you will need to make in the divorce negotiation and in high-net-worth divorces, taxes can represent a significant financial expenditure. Knowledge is power. Know the tax effects of your negotiations.
