When considering divorce, most couples focus on the emotional and financial impact of the divorce. Custody and support issues and the division of marital property tend to dominate most people’s concerns. Unfortunately, many couples fail to consider the short- and long-term tax implications of a divorce until after the proceedings are finalized. The failure to account for the tax implications of divorce can have far-reaching financial implications for each spouse.
Tax Implications Caused by Division of Marital Assets
Divorcing couples frequently spend a great deal of time arguing over the division of assets and liabilities accrued during the marriage. When considering the value of an asset or liability, it is important that the couple take any tax benefit or liability related to maintaining or disposing of that particular asset into consideration.
For most marital assets, the Internal Revenue Service allows for tax-free transfer, which means that if one party gets the marital home and the other party gets the investment accounts, each spouse takes the asset without payment of any transfer or sales tax. In addition, the spouse that owns the asset after the division has the same tax basis in the asset that the couple had prior to divorce. So dividing assets may not create a tax liability, but when the asset is later liquidated or sold, the spouse that currently holds the asset will be liable for the entire tax liability on that asset. If the parties decide to sell any marital assets during the divorce proceedings, the divorce settlement should address how and by whom any capital gains tax will be paid.
Tax Implications Resulting from Spousal and Child Support Payments
Alimony and spousal support payments are considered taxable income for the spouse receiving support. The paying spouse is entitled to a tax deduction for the amount of alimony or spousal support paid. On the other hand, a child support payment are not considered taxable income for the receiving parent, and the paying parent is not entitled to a tax deduction for the amount of child support paid.
Tax Implications When a Divorcing Couple has Children
When negotiating the divorce, the parties should negotiate which parent is entitled to claim the dependent exemption and child tax credit for each of the couple’s children. [highlight]In 2014, the dependent exemption is established at $3,950 per child and the child tax credit is established at $1,000 per child.[/highlight] As a rule, exemptions and tax benefits related to children are granted to the custodial parent. However, the parties are able to negotiate which spouse will receive these exemptions and tax credits.
Similarly, a divorcing couple should consider which spouse would be able to claim head of household status. The benefit of head of household status is that the filer is generally granted a larger standard deduction and will be placed in a more generous tax bracket. To claim head of household status, the taxpayer must file a separate tax return, cannot have resided with their former spouse for more than six months during the tax year, and the child must have lived with the parent for at least six months out of the year. It is possible to claim head of household status even if the child is claimed as a dependent on the other parent’s tax return. Being able to claim head of household status and utilize the dependent exemption and child tax credits can reduce the amount of income tax that is paid each year.
Tax Status and Other Filing Issues During and After Divorce
[highlight]As a rule, the spouse’s marital status on the last day of the tax year will determine their filing status for that year.[/highlight] If a spouse is divorced or separated under a separate maintenance contract on the last day of the tax year, they will be considered single for the entire tax year. If state law in the jurisdiction where the spouse resides does not recognize a decree of separate maintenance, then the taxpayer will not be considered divorced for tax filing purposes until a final divorce decree is entered. [highlight]Until the divorce is finalized, the spouses may choose to file jointly or separately. Once the divorce is final, each spouse must file separately or as head of household.[/highlight] The determination of which status to choose depends on the amount and type of tax liabilities as well as the amount and value of certain deductions and tax credits.
Failure to consider the immediate and long-term tax consequences of divorce may lead to financial difficulties after the divorce because the parties did not have a full picture of their financial future. Having a complete understanding of the tax consequences of the divorce is a vital step in creating a full and fair divorce settlement. That is why working with a divorce attorney can help ensure that all aspects of your divorce are covered so you can go on with you life.