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Navigating the Tax Implications of Divorce

01/25/2016  |  By: Melissa Cothran, CPA, Senior Manager, Tax

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The holiday season is upon us once again, which sadly can bring stress and tension to a marriage. Relationships that are on the verge of breaking often end in divorce after the season has passed. While the process of divorce is already difficult both mentally and emotionally, it can be made even more grueling by encountering unforeseen tax consequences.

Key Considerations When Navigating a Divorce

When engaged in a heated battle of property division, taxes may be the last thing on a divorcing couples minds', but considering the significant impact taxes have on the dollars left on the table, they should be at the top of the list. One misstep in planning often works to the benefit of the tax collector. Below we have summarized some key considerations in the tax arena that deserve attention when navigating a divorce:

Filing Status

This is one of the most frequently asked questions we receive from divorcing couples. The IRS considers a taxpayer who is married on the last date of the year as married, and that couple may file as married filing joint, married filing separate, or in some cases, as head of household. You are still considered married even if you are separated. You are only considered unmarried if you have obtained a final decree of divorce by the last day of the year. 

As most people know, the filing status used on your tax return helps determine whether you can claim certain deductions or credits, and affects your tax rate. A couple that is in the midst of divorce on December 31 can do appropriate tax planning with their tax professional to verify the status chosen is the most beneficial to both parties.

Dependency Exemption

While dependency exemptions can equate to tax dollars saved, there are planning opportunities surrounding which party should take them. The IRS will presume the custodial parent will get the dependency exemption, but the parties can negotiate this piece based on each party's tax situation. The exemption may be most beneficial to the "non-income" spouse (often times the custodial parent), as the benefit could be phased out completely for top bracket taxpayers.

In just the opposite scenario, if the noncustodial parent is not in the top bracket, the exemption may bring bigger savings to him/her. The IRS allows flexibility to negotiate with a Form 8332, "Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent."  This is a written declaration where the custodial parent releases his/her dependency exemption to the noncustodial parent. The Form shall be attached to the noncustodial parent's tax return in each year the dependency is claimed.

Alimony

Alimony, unlike child support, is typically considered income to the recipient and a deduction to the payor. In order for this to be the case, certain criteria must be met: taxpayers cannot file a joint return, payments must be made in cash (including checks or money orders), the payment must be received by the former spouse in the year for which you are taking a deduction, the divorce or separate maintenance decree cannot state that the payment is not alimony, former spouses shall not be members of the same household when payment is made/received, there should be no liability to make the payment after the former spouse is deceased, and your payment must not be considered child support. 

If you are the payor, you do not have to itemize to receive the deduction, rather the full amount paid reduces adjusted gross income on Page 1 of Form 1040.  It is important to include the social security number of the recipient, or you could risk a penalty from the IRS and loss of the deduction.

As briefly mentioned earlier, child support is not taxable to the recipient, and is not deductible by the payor.  To clearly decipher between alimony and child support, it is pertinent that the divorce decree defines the payment as "child support".  As both alimony and child support can have impactful tax consequences, a family law attorney should carefully word the divorce documents.

Deductions in Year of Divorce

Often divorces take months, even years, to finalize and life as we know it continues behind the scenes. A common question taxpayers have relates to division of deductions - mortgage interest, medical expenses, property taxes, and the list goes on. These tax write-offs are considered marital assets and similar to other assets, an agreement must be made by the divorcing couple as to how to divide them. 

For example, if the marital home is occupied by one spouse, but both spouses continue to pay the mortgage, one choice could be to split the deduction equally on the tax return. An alternative agreement may be that one party claim the mortgage interest and the other claim the property taxes. The tax reporting document may still be issued to one spouse, but that doesn't take precedent on who takes the deduction.

What is most important is communication between the parties to ensure that both aren't taking the full deduction, as the IRS will certainly issue matching notices and further fees will rack up in resolving the tax return.

As we've summarized above, there are many tax considerations when navigating a divorce. With proper planning, both parties can retain more tax dollars and give less to Uncle Sam. Many times the most advantageous outcome for both parties comes from projections using various scenarios.  

In addition to tax professionals, LBMC also provides litigation support services to family law attorneys in both traditional and collaborative divorces.  Look for an upcoming article on collaborative divorce in our next issue of the navigator.

Our team of advisors would be happy to help you in these areas should a need arise.