Written by Joseph Bryant, a credentialed tax advisor. Joseph Bryant is also a paralegal working for Freedman Law, P.C. Read more about Joe.
Taxation is a specialized area of law with rules, credits, deductions, and exemptions changing each year. The information contained in this article is for informational purposes, and is not intended to be taken as tax advice applicable to your personal circumstances. Only a personal tax advisor can properly advise you about your personal situation. If your attorney does not handle tax matters, you should seek out the assistance of an Enrolled Agent (tax adviser licensed by the Treasury Department), a tax accountant, tax attorney, or a CPA that handles tax matters.
Which Filing Status should I use?
Generally, your marital status for the tax year depends on the day you obtained your final decree of divorce. However; if you were separated (meaning spouse did not live in the home) the last six (6) months of the year, and you did not intend to stay together in the future, then you are “divorced” under IRS rules. However, this does not mean that you cannot file a joint return with your spouse. Federal laws do not control marriage or divorce, it is all controlled by state law, so the IRS has determined their own definitions. According to the IRS, you are “unmarried for the whole year” if you have obtained a final decree of divorce or separate maintenance by the last day of the tax year. If you are considered married and you choose to file Married Filing Separately, the divorce court may order you to pay over to your spouse the amount that they lost by not sharing in the benefits of jointly filing. If you do not have good cause to file separately, almost always it will be better financially for you to file a joint tax return. There are exceptions to this of course. If your spouse has been cheating on taxes, you have good reason to believe the spouse is involved in a criminal enterprise, or the spouse has created a tax debt for the purpose of making you split the cost, then filing separately may be a good idea. Of course, filing separately though may cause you to lose several tax benefits, especially if you have children. You should consult with a tax adviser or a tax attorney if you believe this is a concern.
Dependency Exemptions for Children
“Who is supposed to claim the kids?” That must be the question asked most often in the middle of a divorce or right after the decree has been entered. The basic IRS rule for claiming a child exemption requires that a child be under 19 years old (or under 24, if a student) or any age if the child is permanently disabled. A child is considered a “qualifying child” for exemption purposes for the custodial parent. A custodial parent is “the parent with whom the child lived for the greater number of nights during the year.” The other parent is the noncustodial parent. Depending on several factors, generally there are up to 7 tax benefits that a parent may receive when claiming a child. For tax years 2018 and 2019, only one benefit is now transferable to the non-custodial parent and that transfer must be done with IRS Form 8332. The court may order that the non-custodial parent receive a child exemption every other year for tax purposes. Though the Court often does not explain it in laymen’s terms, the procedure for the non-custodial parent to claim those children is not explained to the parties, if at all.
The IRS defines alimony as “a payment to or for a spouse or former spouse under a divorce or separation instrument. It does not include voluntary payments that are not made under a divorce or separation instrument. Alimony, prior to 2019, was deductible by the payer and had to be included in the spouse’s or former spouse’s income. Child support, non-cash property settlements, payments that are your former spouse’s part of community income, payments to keep up property owned by the paying spouse and use of the property owned by the paying spouse are not considered alimony for IRS purposes. Indiana does not have “Alimony.” However, for court orders entered by the Court after January 1, 2020, alimony payments are no longer deductible to the payor and the payee also is not required to report the alimony as taxable income. Scheduled payments that are from a division of the marital assets is a “present property interest” and not maintenance. There are no tax ramifications to making those scheduled payments.
Retirement Accounts, QDROs, and IRAs
Retirement accounts (IRA, 401-k, 403-b and many others) are often the largest asset or assets in a marriage. It may be necessary to divide one or more of these accounts. This can create tricky issues involving tax basis, tax liability, administrative fees and transfer logistics. In general, employment-based retirement accounts are governed by a federal statute know as ERISA (The Employment Retirement Income Security Act of 1974) . To transfer a share of an ERISA-based 401-k requires a special court order. This order needs to be signed by all parties and attorneys and the Court. Then it is sent to the plan administrator who will determine whether it is a “Qualified” Domestic Relations Order (commonly known as a QDRO). The process of getting pre-approval, court approval and final approval of the domestic relations order can sometimes be a challenge. However, most plan administrators have sample orders or instructions, which can make the process much easier.
IRAs do not have the same restrictions, and can be divided more easily through use a transfer form from the applicable bank or brokerage.
The receiving spouse needs to do some legwork to determine what to do with the retirement funds he or she is receiving. If the receiving spouse simply rolls the money into their own retirement plan, there will be no penalties or tax owed; however, if the receiving spouse uses that money like cash, it will become taxable and may potentially carry penalties with it. Please speak with a knowledgeable tax attorney, tax adviser, or financial adviser to be certain. You may be advised to roll the funds into your own IRA. If you need access to cash quickly, look into how you might be able to borrow from the IRA and pay it back over time without suffering the tax consequences or the penalties for just using the money. Some people are eligible to escape penalties if they qualify for certain exemptions. As these change often, you should speak with a tax advisor or tax attorney.
If you have children and your income is less than $44,000 per year, keeping the retirement funds — instead of rolling them into another plan — will increase your gross income. In addition to moving you into a higher tax bracket, the higher income may cause you to lose the Earned Income Credit or other credits you might otherwise have been entitled to receive.
Capital Gains and Losses
Some assets transferred in the divorce may come with a tax basis (original price or adjusted). This in turn may result in capital gains or capital losses when the asset is sold. A tax professional familiar with divorce issues should be able to advise you concerning the tax aspects of any asset you may receive. Assets which may result in capital gains or losses may be a residence, other real estate, rental properties, stocks, bonds, mutual funds, or shares of company stock. The length of time these have been owned may also make a significant difference as the tax rates for short-term and long-term capital gains are different. Long term gains are taxed at a much lower rate to encourage people to hold the investments longer while short-term gains are taxed at your regular income tax rate. If you have losses, up to $3,000 can be deducted in their current year, and any excess is carried over to future tax years. If your last joint tax return had losses that were still being carried over, it should be addressed in your divorce case as those losses stay with one person until exhausted. Again, these are fact specific issues in which a tax professional should be consulted.
Property Settlements and Sale of Joint Property
There is no recognized gain or loss when you transfer property between spouses or former spouses if the transfer is part of a divorce.This is true even if the transfer was “in exchange for cash, or the release of marital rights, the assumption of liabilities, or other consideration.”
Donations and Other Deductions
If both parties to a divorce have both donated money or property to charity, the deduction for the donations will need to be allocated. Just like capital gains and losses, excessive prior year qualified contributions can be carried forward for up to 5 years.
For those that are able to file Schedule A (itemized deductions) with their federal returns, medical expenses, property tax deductions, and mortgage interest, for those that are able to file a Schedule A, may also need to be allocated.