During the tumultuous end of a marriage, spouses seek counsel from therapists, friends, family, and ministers. Few spouses think of asking their CPA about their divorce. Divorce has several tax consequences. I recently spoke with a man who received a $40,000 tax bill following his divorce (ouch) at the same time he started paying spousal and child support. So, what are the tax ramifications of divorce?
1. January is a Beautiful Month for New Beginnings (and divorce)
When you marry, the IRS gives you this great new deduction. Few people think about the flip-side of that deduction at the end of marriage. The IRS doesn’t care if you were married for part of a year—they only grant you the deduction for being married if you are married the entire year. The significant date is the finalization of the divorce. The problem with that date is that it is somewhat hard to predict. In California, divorces become final six months after judgment.
However, especially when issues are contested it can be uncertain when things will get finalized. The worst thing that can happen is that a spouse claims their dependent spouse all year long, a divorce is finalized in December, and come April that spouse gets a big tax bill. Attorneys can help their clients by working slowing or expediting the process to help avoid finalization of the divorce at the very end of the year (like December).
2. Sell the House Fast or First (what’s better than capital gains?)
Generally speaking, capital gains are long term investment gains that are taxed at a lower rate. Capital gains are your friend. However, the IRS has something even better in store for taxpayers who are married and sell real estate. Under the tax code (28 USC § 121) if you use real estate as your principal residence for over two years, you can exclude $250,000 of gain if you are single, or you can exclude $500,000 if you are married filing a joint return. Exclusion means just that—you don’t have to pay taxes on that gain at all.
So, if you get divorced, then sell the house you only get to exclude $250,000 from gain. If you are lucky enough to be looking at gaining over $250,000 from the sale of the property, couples should consider selling the property before finalizing a divorce. The difficulty is that given the harsh real estate market, couples may have the property sitting on the market for some time before the property can be sold. However, avoiding tax liability on another $250,000 worth of gain may be worth the wait.
3. Goodbye Tax Deduction (children as dependents)
The IRS helps families by giving deductions for children (a policy that I think is ridiculous and unfair to those without children like me, but I digress). Post-divorce, the spouse whom the court designates as the custodian of the child gets to claim the deduction. So, the noncustodial spouse loses the deduction. If a spouse had been claiming that deduction all year long, then loses custody in December, that can hurt come April.
But, it gets more complicated: what happens when parents share custody 50/50? It’s up to parents to figure out who gets to claim the child as a dependent. If there are 2 children, most parents agree to each take one of the children as a dependent. If there is one child or an odd number of children, parents usually switch use of the claim each year. The parents simply need to be careful not to both claim the same child as a dependent, as the IRS will notice and will not be happy. Whenever parental custody will be shared 50/50, parents should negotiate the claim of children as dependents on taxes as a part of the divorce settlement.
4. Spousal Support Payments (the double-edged sword)
Spousal support is a double-edged sword for both parties. For the obligated party (payor), they have to pay support, but can claim spousal support as an above-the line deduction. That means spousal support does not need to be itemized. Above the line deductions are better than below the line deductions as the deduction is taken before arriving at one’s adjusted gross income. So, although the breadwinner may have lost several tax deductions (ouch) and is obligated to pay support (ouch), at least they get to claim spousal support as a deduction.
However, for the payee, things aren’t all cheery. Although they are receiving support, spousal support is taxable income.
5. Child Support Payments (hear no evil see no evil)
For whatever reason, child support is a non-taxable event. It is not deductible for the party paying. It is also not claimed by the person receiving the child support. It is completely tax-neutral. This is one of the few transactions that the IRS doesn’t care about.