The below discussion highlights some of the most common tax issues in divorce.
Tax Filing Status
Under the Internal Revenue Code, there are five tax rate schedules for individuals and couples:
- single;
- head of household;
- married filing separately;
- married filing jointly; and,
- qualified widower with dependent child.
Determining the filing status of the parties is often a major consideration in a divorce. Most divorcing spouses prefer to file under the schedule that results in that spouse’s lowest overall tax liability. It is critical that the parties consult with a tax advisor to understand their tax filing options and to determine the most beneficial tax filing status based on their specific circumstances.
Joint or Separate?
Whether filing separately or jointly will result in a spouse’s lowest overall tax liability depends on a number of factors, including the assets owned by each spouse, the income earned by each spouse, whether one or both of the spouses have made or failed to make estimated tax payments, whether one spouse has paid spousal maintenance to the other, whether one spouse is likely to incur future tax liability for taxes owed during the marriage, and whether one spouse would qualify for head of household status.
Filing jointly often results in both parties’ lowest overall tax liability, but, to file jointly, the parties must be legally married on December 31 of the year for which the return is filed. In certain situations, it may make sense to delay filing the divorce action to ensure that the parties are legally married on December 31 to take advantage of the tax rules benefiting couples filing jointly. Spouses who file married filing separate returns usually (with limited exceptions) have the option to amend their returns to file a joint return with his or her spouse within three years of the original tax return due date, as long as they were legally married on December 31 the applicable tax year. Spouses who file a joint return, however, may not later amend their returns to file separately. When divorcing spouses do not agree on the issue of electing a tax filing status, it may make sense for them to initially file separate returns and later decide whether to amend their returns to file jointly.
Filing jointly does have risks. If a joint return is filed, both spouses have joint and several liability for all tax due on the return, including interest and penalties. If one spouse fails to pay the tax due on the return, the other spouse may be required to pay the full amount of the joint tax liability. In this situation, the tax authorities may levy upon and seize a spouse’s non-marital separate assets to pay the tax debt of the other spouse. On the other hand, if the spouses file separately, each spouse’s tax liability is determined separately and a spouse is not responsible for paying the other spouse’s tax debt. In this situation, only the separate assets or separate interests in joint assets of the spouse who actually incurred the tax may be levied upon and seized to pay that spouse’s individual tax debt. Thus, in some circumstances, the lower-earning spouse may be better off filing separately to avoid the possibility of being held liable for his or her spouse’s or ex-spouse’s tax debt, especially if the lower-earning spouse owns or expects to receive significant separate assets (such as through an inheritance).
In some cases, a spouse who filed jointly may be relieved of liability for his or her spouse’s tax liability. To qualify for “innocent spouse” relief (under I.R.C. §6015(b)), a spouse must meet all of the following conditions:
- He or she must have filed a joint return which has an understatement of tax;
- The understatement of tax must be due to erroneous items of the other spouse;
- He or she must establish that at the time he or she signed the joint return, he or she did not know, and had no reason to know, that there was an understatement of tax;
- Taking into account all of the facts and circumstances, it would be unfair to hold the innocent spouse liable for the understatement of tax; and
- He or she must request relief within 2 years after the date on which the IRS first began collection activity against him or her.
- However, where a spouse had actual knowledge of the understatement of tax but did not challenge it due to fear of domestic abuse by the other spouse, such actual knowledge will not automatically preclude innocent spouse relief;
As a practical matter, it may sometimes be difficult to establish the facts required for relief under the innocent spouse rule. Even if a spouse does not qualify for innocent spouse relief, he or she may qualify for “separation of liability” (under I.R.C. §6015(c)) or “equitable relief” (under I.R.C. §6015(f)) and be relieved of having to pay his or her ex-spouse’s tax debt.
Head of Household
If the parties have children, one or both of the spouses should be eligible to file their post-divorce federal income tax return as head of household, which generally results in a lower tax liability than the single rate.
Generally, the parent who has the children more than one-half of the year may claim head of household filing status. If the parents have more than one child and each parent has at least one different child living with him or her for more than one half of the year, both parents can claim head of household filing status. A parent claiming head of household filing status may also qualify for other tax benefits such as the Dependent Care Credit, the Earned Income Tax Credit, and other tax benefits.
In some cases, it is possible for a spouse who is not yet legally divorced to qualify for head of household status. A married spouse may generally qualify for head of household status if he or she has lived apart from his or her spouse for the last six months of the taxable year and provides more than half the cost of maintaining a household that is the principal place of abode of that spouse’s dependent child for more than half the year. Head of household status is based in part on actual physical custody of the child and may not be “transferred” to the other spouse as part of settlement negotiations. Whether head of household status will result in a lower tax liability than married filed jointly or married filing separately depends on a number of factors, and the spouse should consult with his or her tax advisor to determine the most advantageous filing status.
Child Dependency Exemption
Under Colorado law, the child dependency tax exemption is allocated based on the parent’s financial contributions to the cost of raising the child. Colorado courts allocate the dependency exemption based on the child support percentages shown on the child support worksheet as opposed to the actual amount spent by each parent on the child. For example, if one parent pays 60% of the total support for the child as reflected on the child support worksheet, the court may allocate the dependency exemption to that parent for the first three out of five years, and the other parent for the next two out of five years. A parent who is obligated to pay child support can only receive the dependency exemption if he or she has paid all court ordered child support for the tax year in which the dependency exemption is claimed, and he or she may not claim the dependency exemption if it would not result in a tax benefit to him or her. The “custodial” parent typically needs to complete IRS Form 8332 for the “non-custodial” parent to claim the dependency exemption.
Child Support Deductibility
Generally, child support payments are not deductible to the payor and are not included in the payee’s gross income.
Maintenance (Alimony) Deductibility and “Recapture”
Generally, maintenance (alimony) payments are deductible to the payor spouse and included in the recipient spouse’s taxable income. Maintenance payments can be structured to maximize the after-tax benefit to the recipient spouse and minimize the after-tax cost to the payor spouse.
Be aware that there are possible tax deductibility “recapture” issues for maintenance awards of less than three years, due to Internal Revenue Service recapture rules that occur in the third post-separation calendar year after payments begin. (IRC § 71(f)). The “recapture rule” applies when maintenance payments decrease substantially or end during the first three post-separation calendar years. A “substantial decrease” occurs either: (a) when the maintenance amount paid in the third year plus $15,000 is less than the amount paid in the second year, or (b) when maintenance payments in the second and third years are averaged and this average plus $15,000 is less than the payments made in the first year. If either of these scenarios apply, then the payor will be required to “recapture” in the third post-separation year any “excess alimony” paid during the first and second years, and will be required to report the recaptured amount as taxable income. There are four exceptions to the recapture provisions: (1) when payments cease due to death or remarriage; (2) where temporary support payments are paid pursuant to court order; (3) where fluctuating payments are not within the control of the payor spouse; and (4) where payments decline by $15,000 or less over the three-year period.
Attorney Fees May Be Tax Deductible
Attorney fees and other litigation costs are tax deductible to the extent they are incurred to produce taxable income. Because maintenance (alimony) is generally includable in taxable income, attorney fees incurred in obtaining or modifying maintenance or in collecting delinquent maintenance payments are deductible to the extent such maintenance is taxable to the recipient. Attorney fees and costs incurred to obtain an interest in a spouse’s retirement plan are usually tax deductible because the distributions will be taxable when received. Attorney fees and costs incurred to obtain residuals, royalties, or other taxable income may also be deductible. Child support, on the other hand, is not taxable to the recipient, so attorney fees and costs incurred to obtain child support are not tax deductible.
An expert witness’s fees may also be tax deductible to the extent such fees were incurred to obtain taxable income or maintenance. For example, fees incurred for a vocational evaluation of the other spouse, or fees incurred for an accountant or business valuation expert to determine the other spouse’s business cash flow, may be deductible to the extent such work resulted in an award of maintenance or other taxable income to the spouse who incurred the fees. Attorney fees and costs incurred for tax planning advice are deductible. Attorney fees and costs incurred in establishing or defending title to property may be capitalized and added to the basis of the property, thereby reducing the capital gains tax due when the property is sold.
It is often possible for both spouses in a divorce to benefit from the deductibility of certain attorney fees and costs. For example, if the first spouse pays maintenance to the second spouse and the second spouse then pays his or her attorney fees from the maintenance payment, the first spouse may deduct the maintenance payment from his or her taxable income and the second spouse may deduct the paid attorney fees from his or her taxable income to the extent such fees were incurred for the production of taxable income or for tax advice.
Attorney fees and litigation costs are deductible only to the extent they exceed 2% of the taxpayer’s adjusted gross income in a given year, and are subject to a phase out when the taxpayer’s adjusted gross income exceeds a certain amount. The spouse should therefore pay as many of the deductible legal fees and costs as possible in one taxable year to take full advantage of the 2% rule.
Taxation of 401(k)s and Traditional IRAs in a Divorce
To transfer 401(k) funds from one spouse to another spouse in a divorce, it is necessary for the court to issue a Qualified Domestic Relations Order (QDRO). The transfer of 401(k) funds in divorce cases are not taxable transfers. The transfer of 401(k) funds is not considered an early withdrawal and is not subject to the 10% early withdrawal penalty. Once the 401(k) funds are transferred from the Participant spouse’s account, the recipient spouse has the option to receive the funds in cash or may roll the funds into his or her own IRA or other retirement account. If the recipient spouse elects to receive the funds in cash, there is an automatic 20% withholding for federal income taxes and the funds are ultimately taxed at the recipient spouse’s regular income tax rate for the year which the funds were received. If the funds are rolled into the recipient spouse’s retirement account, the recipient spouse will be taxed on the funds at his or her regular income tax rate when the funds are withdrawn from the account at retirement.
A QDRO is not necessary for a spouse to transfer IRA funds to the other spouse in a divorce. The transfer of IRA funds in divorce cases are not taxable transfers. Most financial institutions that sponsor IRAs have simple forms that the spouses can fill out to accomplish the tax-free transfer of the IRA funds in connection with a divorce. The transfer of IRA funds is not considered an early withdrawal and is not subject to the 10% early withdrawal penalty as long as the recipient spouse rolls the funds into his or her own IRA or other retirement account. Unlike in a 401(k) transfer, the recipient of IRA funds in a divorce does not have the option of receiving the funds in cash without paying the 10% early withdrawal penalty. The recipient spouse will be taxed at his or her regular income tax rate when Traditional IRA funds are withdrawn from the account at retirement.
Capital Gain and Loss Considerations in Allocating Assets
The Internal Revenue Code provides favorable treatment to divorcing spouses pertaining to allocation of property. Property transferred between divorcing spouses is generally treated as a gift. “Cost basis” and “holding period” carry over to the recipient spouse, and the transfer most often avoids treatment as a taxable event.
In analyzing a divorcing couple’s investment portfolio for purposes of asset allocation, it is important to determine any unrealized gains or losses on capital assets and the potential taxes that will result from the ultimate sale of these assets. The sale of assets with a lower tax basis will likely result in a higher capital gains tax liability than the sale of assets with a higher tax basis. Thus, allocating capital assets between the spouses based solely on the current fair market value of the assets, without considering the unrealized gains or losses on these assets, may result in one spouse ultimately paying a disproportionate share of the parties’ total capital gains tax liability. In determining the allocation of capital assets between the spouses, it is important to consider the likely capital gain or loss on the assets to ensure that the allocation is economically equitable. For example, if the Wife receives an investment account worth $100,000 with an unrealized tax liability of $30,000, and the Husband receives an after-tax checking or savings account worth $100,000, Wife received an unequal allocation despite the appearance that both parties received $100,000.
Capital Loss Carry Forward
A capital loss results when a capital asset (such as stock) is sold for less than its purchase price. If net capital losses in a given tax year exceed net capital gains by more than $3,000, any excess over the $3,000 must be carried over to the following tax year and included in the calculation of net capital gains and losses for that year. This is known as a “capital loss carry forward.” A capital loss carry forward is an “asset” that is often overlooked in divorce cases. Capital loss carry forwards often have significant value because of the future tax savings to the taxpayer who is able to claim them. If the sale of securities in a jointly-owned account results in a capital loss carry forward (this can usually found on page 2 of Schedule D), the allocation of the capital loss carry forward may be divided equally between the parties, in which case each spouse would report 50% of the capital loss carry forward on his or her post-decree tax return. If the sale of securities in a solely-owned account results in a capital loss carry forward (even if the securities are considered “marital” under Colorado law), the spouse who owns the securities must claim the capital loss carry forward because capital loss carry forwards generated from the sale of assets owned by one spouse only are not assignable under the Internal Revenue Code. In this event, the parties should consider an offset of other assets in favor of the non-owner spouse to equalize the benefit.
The Marital Home
A married couple’s principal residence is a capital asset. Generally, if the residence is owned and used by the spouses as their principal residence for two out of five years before the sale of the residence, then a gain of up to $250,000 on a separate return or $500,000 on a joint return can be excluded from taxation. If a spouse maintains ownership of his or her primary residence with an ex-spouse, he or she may include the ex-spouse’s ownership period in determining whether the two-year test is met. A spouse who receives a residence outright as part of a divorce settlement or decree may use the ex-spouse’s ownership period in determining whether the two-year test is met.
If there is still a gain after this exclusion is applied, any unused capital loss carry forward can be applied to such gain. Any remaining gain will be taxed at capital gains tax rates. The sale of a principal residence that results in a loss is not deductible and does not create a capital loss carry forward.
Conclusion
The above discussion highlights some of the most common tax issues in a divorce. Always consult with a tax professional to determine how the tax laws apply to your specific situation.
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