Wednesday, February 03, 2010

The Tax Man meets the Divorce Judge: A Horror Story

Tax implications can significantly alter a divorce settlement - sometimes with a severe and inequitable impact. A resolution that seems great at first blush could take a dive into catastrophic waters once you figure the bite of tax consequences.

You take this, I’ll take that (Division of Property)

Generally, transferring property or money from one entity or person to another can trigger a tax. Examples are: (1) income tax (employer/employee transaction); (2) gift tax (donor/recipient transaction); and (3) transfer tax (buyer/ seller transaction). However, a transfer of property as part of a divorce settlement is generally not subject to income tax or transfer tax. The transaction, however, could still have tax consequences. Caveat Emptor!

The basis (defined as the cost for determining taxable gain) of the property transfers with the property and may create a tax liability for the spouse who receives the property if the property is later sold. By way of example, if a couple owns $50,000 worth of stock and a $50,000 savings account, it would most likely not be an equal split to have each spouse take one of these assets. The $50,000 bank account would have virtually no income tax consequences connected with it. However, if the stock was originally purchased for $10,000, then it would have a tax basis (cost) of $10,000. The person who gets the stock in the settlement could pay tax on $40,000 of gain if the funds are later sold for $50,000. If the capital gains rate at the time is 15% - that is a $6,000 tax bite.

When dividing property at the time of divorce, any potential tax liability should be factored into the valuation of the assets. In the above scenario, the person who received the stock would actually receive less than the person receiving the bank account, considering the tax consequences, even though they are both receiving a $50,000 asset. To resolve this dilemma, parties could divide both assets equally, thus dividing the tax consequences. Parties could also attempt to compensate for the tax consequences, but this could be risky and uncertain as tax rates change.

I have to pay him/her how much? (Alimony)

Alimony is generally deductible by the person paying it and taxable to the person receiving it. This means that the after tax cost of alimony can be much less than the actual payment. Parties should be cautioned that any portion of a payment that is specified as support for the couple’s minor children is not considered alimony because it is really just disguised child support.

The IRS defines alimony very specifically. To be alimony for tax purposes, it must be a payment under a divorce or separation written document and the spouses must file separate tax returns. (Yes - must be written!) Additionally, the payment must be cash, check or money order. (Payment through a court system, such as PA SCDU or NJ Probation, also qualifies. However, bartering good and services or payment of someone’s bills does not). The spouses must live separately and the document must specify that the payments terminate upon the recipient’s death.

In order to ensure that the payments deducted as alimony are not disguised property settlements (which are nondeductible), the tax regulations provide certain limitations on the term of payment and the fluctuation in the amount of annual payments. If the IRS find something fishy, payments could be recharacterized, thus resulting in a tax mess - back due taxes plus penalties and interest.

Both spouses’ tax situations should be considered in determining whether the amounts paid qualify as alimony or not. The benefits would depend on the respective spouses’ tax brackets. For example, shifting income to a spouse with a lower tax bracket means less money for Uncle Sam and more for the family unit (albeit a divorced family unit).

My child support is how much? (Child Support)

Unlike alimony, payments made for child support are not deductible by the parent paying them, and they are not income to the parent receiving them.

As mentioned previously, child support may not be disguised as alimony. Payments not designated as child support will generally be reclassified as child support if they are to be reduced by a certain event in the child’s life (i.e., when the child reaches a certain age, graduates, leaves home, etc.). Careful drafting can avoid this reclassification.

But I want to claim my kids! (Dependency Exemption)

The law states that the custodial parent is generally entitled to the dependency exemption on their income tax return for children unless the custodial parent waives the right to the exemption in writing. Judges in family law matters can also allocate the exemption as they see fit. Sometimes, the dependency exemption is used as a bargaining chip.

The parent who maintains a home for a dependent child for more than half of the year may still qualify for the earned income credit, the child care credit, and the head of household rate even if that parent has waived the dependency exemption to the non-custodial parent. When parents share custody, the tie breaker for the dependency exemption, absent agreement, is usually based on each parent’s income.

The parent who pays the child’s medical expenses may claim them along with his or her own, regardless of which parent gets the dependency exemption. However, as there is a threshold for deducting medical expenses, not everyone may be eligible for this tax break.

We’re moving on up! (Sale of Residence)

The tax rules governing the sale of your home dictate that most sales will be tax-free unless your house has increased significantly in value from the date you purchased it. The law exempts from taxation profits on the sale of your home of up to $250,000 for singles and $500,000 for couples. The profit is based on the gain, that is, the sale price minus the original purchase price, adjusted for any additions to basis along the way.

Please note that to qualify for the exemption, you must have owned the home and occupied it as your principal residence for at least two of the five years prior to the sale.

I paid my lawyer an arm and a leg - can I at least deduct it? (Deductible Fees)
The cost of getting a divorce is not deductible. However, legal fees that relate specifically to a property settlement may, in some circumstances, be added to the basis of the property. Fees paid for obtaining alimony and for tax advice in connection with the divorce are deductible as miscellaneous itemized deductions. Of course, as with most other itemized deductions, your deduction may depend on your AGI and is subject to a floor and other specific rules.

Saving for the golden years. (Retirement Accounts)

Dividing up retirement benefits also presents tax challenges in a divorce. Normally, early withdrawals from a retirement account trigger both penalties and taxes. However, you can divide the benefits of a qualified retirement plan without tax consequences if you obtain a Qualified Domestic Relations Order (QDRO). Even then, however, the rules are complex and the consequences of an error can be severe. Other retirement benefits, such as IRAs, can usually be transferred without a QDRO, but the transfer must still be carefully structured to avoid unplanned tax results. Additionally, the receiving spouse will usually receive the assets as a retirement benefit and will generally not be able to liquidate it prior to retirement age without penalties and taxes.

Who gets what when I die? (Life Insurance, Wills and Estate Planning)

Any change in family status should be followed immediately by a review of life insurance, wills, estate plans and anything with a named beneficiary. In the case of significant assets, children, subsequent marriages and/or a family business, this review becomes imperative. At the time of a divorce, all health, life, disability, auto, home, and other insurance policies should be read and re-evaluated. Change amounts of coverage and beneficiaries if warranted.

Obtain competent advice. (Accountant)

As with all rules, tax laws and regulations are subject to exceptions and interpretation. When negotiating your divorce, consult with a qualified accountant.
For comprehensive materials published by the Department of Treasury, Internal Revenue Service, visit


Nicola Baume - Divorce coach said...

This is the second post I've read today about the tax man taking settlement money. I live in Australia and the tax department here does not tax divorce settlements, so you can change ownership on assets without being taxed. Maybe you should lobby for that as well.



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