Tax Issues in Divorce

Divorce is full of serious questions and implications for your future. One of these is how to handle your taxes during and following divorce. Some of my clients haven't touched a tax document in several decades, so it can be even more difficult to understand how things like spousal maintenance, child support and other issues will be accounted for come April 15.

The following provides an overview of the different ways divorce and taxes come together, but it is for general knowledge only. Tax laws change frequently, and any decisions you make in your divorce should be done with the help of an experienced lawyer and certified public accountant.

Please note that legal fees related to divorce proceedings are never tax deductible.

What Status Should I File As?

Filing your taxes is determined by your marital status as of Dec. 31 of the previous year, that is, the year that you are filing taxes for. If you were still married as of Dec. 31 of the previous year, you can file taxes either jointly or separately, but filing jointly means both parties will be responsible for paying any tax liabilities that are assessed.

If you still live together after your divorce, you must file separately and as the "head of household" even though you still share an address with your ex.

You should also be aware that those who choose "married filing separate" are taxed at the highest rate, so it would be worth talking with a skilled lawyer or your financial planner if you are in the midst of a divorce.

Assessing Tax With Regard To Custody And Child Support

Child support is never taxable for either the parent who pays or the parent who receives the support, since the support technically goes to the children. However, the custodial parent can claim the children on his or her taxes if he or she provides at least half of the financial support, unless the parent has given up his or her rights to this exemption or parents share physical custody of the children.

Alimony And Taxes

Alimony can be taxed for both the payer and recipient provided the following requirements are met:

  • Alimony was awarded as part of a divorce or legal separation
  • Spouses do not live in the same household
  • Payments received are designated as alimony payments
  • Payments are not treated like child support
  • Parties do not file a joint tax return

Taxability Of Assets Distributed In A Divorce

The "equitable distribution" of assets is generally not taxable. Under the Internal Revenue Code Section 1041 (a), no gain or loss is recognized on the transfer (acquisition or distribution) of assets provided these transfers occur within one year after the divorce or related to the ending of the marriage.

Note, however, that there are transfer taxes for New York City and New York State that may be due on the equitable share of a marital home that is transferred from one spouse to the other. If, however, the principal residence is sold, the person who has lived in the house for at least two out of the last five years could be eligible for an exclusion of capital gains tax.

Deducting Mortgage Payments, Interest And Real Estate Taxes

If your home is jointly owned and the mortgage paid from joint account (i.e., if you're married filing jointly), the court assumes payments are distributed 50-50. When you get divorced, you must keep the following general rules in mind:

  • If the person who pays the mortgage is not living in the home, he or she can deduct interest on the mortgage and real estate taxes on his or her return. The person who lives in the home and isn't paying the mortgage may be required to then report mortgage payments as income (alimony) but may then also deduct the interest and real estate taxes.
  • If the home is owned by the person who primarily lives in it, that spouse who does not can only deduct mortgage interest (not real estate taxes) if their minor child lives in the home.
  • If the home is solely owned by the person who is not living in it and pays everything, then he or she can deduct everything (mortgage, interests and real estate taxes) and the person living in the home does not have to report payments as alimony.

Understanding Taxes And Retirement Plans

When you get divorced, your retirement plans may be thrown off because it's possible you gave up a career — and thus a retirement plan — to take care of your family. A Qualified Domestic Relations Order can be useful in these situations, because it allows you to claim and set aside a portion of your spouse's tax-deferred benefits for when you retire. As such, these assets will not be taxed until they are distributed, not when the QDRO was created.

It's important to note that tax-exempt benefits, like IRAs, cannot be put into a QDRO. Furthermore, transferring interest in stock or deferred compensation plans cannot be taxed, though income must be reported when these stock options are used or when the deferred compensation plans are paid out.

Seeking Innocent Spouse Relief

By requesting innocent spouse relief, you may be relieved of the responsibility for paying tax, interest, and penalties if your spouse (or former spouse) improperly reported items or omitted items on your joint income tax returns. Generally, the tax, interest and penalties that qualify for relief can only be collected from your spouse (or former spouse). If you do not qualify you are jointly and individually responsible for any tax, interest and penalties. The IRS can collect these all or part of any amounts from either you or your spouse (or former spouse).

You must meet all of the following conditions to qualify for innocent spouse relief:

  1. You filed a joint income tax return, which has an understatement of tax due to erroneous items (defined below) of your spouse (or former spouse).
  2. You establish that at the time you signed the joint income tax return you did not know, and had no reason to know, that there was an understatement of tax.
  3. It would be unfair to hold you liable for the understatement of tax.

A request for innocent spouse relief will not be granted if the IRS establishes that you and your spouse (or former spouse) transferred property to one another as part of a fraudulent scheme. A fraudulent scheme includes a scheme to defraud the IRS or another third party such as a creditor, ex-spouse or business partner.

Errors In Tax Reporting

The following issues can cause problems during or following divorce, just as they can when you were married:

  • Unreported income. This is any gross income item received by your spouse (or former spouse) that was not reported.
  • Incorrect deduction, credit or basis. This is any improper deduction of tax due to that item. You and your spouse (or former spouse) remain jointly liable for that part of the understatement.

Experience Matters When It Comes To Understanding Divorce And Taxes

Only an experienced and seasoned divorce attorney will know all of the tax implications relating to your divorce action. Contact my office in Staten Island at 718-720-1000 to talk through your questions and concerns with me, Kurt T. Richards.