The following information can be helpful for individuals facing a divorce or legal separation.
Where one spouse is to be making support payments to the other upon divorce or separation, the payments are deductible by the payor and taxable to the payee if they qualify under the tax rules for “alimony.” To qualify, the payments must (i) be required under the divorce decree or separation agreement (i.e., voluntary or “extra” payments won’t qualify), (ii) be in cash only (not goods or services), and (iii) be required to end at the death of the recipient spouse. Also, (iv) the parties must be living in separate households. The parties can elect to have payments that qualify be treated as not qualifying (but not vice versa).
Support payments for children (“child support”) aren’t deductible by the paying spouse (or taxable to the recipient). These include payments specifically designated as child support as well as payments which otherwise might look like alimony but are linked to an event or date related to a child.
Tax planning for support payments generally seeks to make them deductible if the paying spouse is in a higher tax bracket than the recipient, as is often the case. The tax savings for the paying spouse can be shared with the recipient through higher payment amounts or other benefit provisions. For example, if having payments qualify as alimony will save the paying spouse $5,000 in tax and will cost the receiving spouse only $2,000 (determined by multiplying the alimony amount by the individual’s marginal income tax bracket), the paying spouse can offer additional payments in the divorce negotiations to cover the recipient’s tax cost and a share of the additional tax savings.
Since alimony payments are required to end at the death of the receiving spouse, as noted above, the parties may wish to provide for life insurance for that spouse as part of the arrangement.
To some extent, the parties can determine who is entitled to claim the dependency exemption for their dependent children. The exemption for the child goes to the spouse who has legal custody of the child. However, that spouse can waive his or her right to the exemption, thus allowing the non-custodial spouse to claim it. In general, tax planning calls for the spouses to agree to have the exemption go to the spouse who can extract the greater tax benefit from it. As discussed above in connection with tax savings from support arrangements, the tax benefit can then be “shared” with the other spouse via increased support payments or in some other fashion.
The dependency exemption entitles the spouse who claims it to more than just the exemption. For example, the child tax and the higher education (Hope and Lifetime learning) credits are only available to the spouse who claims the child as a dependent. (Note, however, if the custodial parent waives the right to the exemption, the custodial parent can still claim the child care credit for qualifying expenses if the child is under 13.)
If a custodial spouse is waiving the right to the dependency exemption for a child, it’s done on Form 8332. This can be done on an annual basis or one time to cover future years. Where the waiving spouse will be receiving support payments from the other spouse, the waiving spouse often prefers the annual approach so he or she can refuse to grant the waiver if support payments are late or have been missed.
When property is split up in connection with a divorce, there are usually no immediate tax consequences. Thus, property transferred between the spouses won’t result in taxable gain or loss to the transferring spouse. Instead, the receiving spouse takes the same basis (cost) in the property that the transferring spouse had. (The receiving spouse may have to pay tax later, however, when the recipient spouse sells the property. For example, if a spouse receives a $300,000 vacation home, but the transferring spouse’s basis was only $150,000, the recipient spouse will have a taxable gain if he or she later sells the house for more than $150,000, unless the spouse qualifies to exclude part or all of the gain by first making the house his or her principal residence). This “nonrecognition rule” also applies to certain transfers, incident to divorce, to a spouse or former spouse, of so-called nonstatutory stock options and/or rights to nonqualified deferred compensation that an individual has received as compensation for employment and that haven’t yet been recognized for income tax purposes. Moreover, the transferee spouse or former spouse, rather than the transferor, is taxed on the income attributable to these transferred options or deferred compensation rights.
In general, if a married couple sells their home in connection with divorce or legal separation they should be able to avoid tax on up to $500,000 of gain (as long as they owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out. If the couple doesn’t meet the two year ownership and use tests, any gain from the sale may qualify for a reduced exclusion by reason of unforeseen circumstances.
When certain types of business interests are transferred in connection with divorce or separation, care must be taken to make sure “tax attributes” aren’t forfeited. In particular, interests in S corporations may result in “suspended” losses, i.e., losses that are carried into future years instead of being deducted in the year they are incurred. Where these interests change hands in connection with a divorce, the suspended losses may be forfeited. If a partnership interest is transferred a variety of more complex issues may arise involving partners’ shares of partnership debt, capital accounts, built-in gains on contributed property, and other complex issues.
Deducting legal fees
Finally, to what extent can you deduct the legal fees incurred in connection with the divorce? In general, since a divorce is a “personal” undertaking, the legal fees are nondeductible. However, as you can readily see from this discussion, many complex tax issues can be involved in a divorce. And a fee paid for tax advice (including setting up the support arrangement), is deductible as a miscellaneous itemized deduction. (This means it’s added to other items in this category, if any, e.g., investment expenses, and is deductible to the extent the total exceeds 2% of adjusted gross income.)
To get a tax deduction for the part of your legal fee that represents tax advice, it’s important to have your attorney indicate on his or her bill to you what portion represents tax-related service. If your attorney merely submits a bill “for legal services rendered” you may have difficulty convincing IRS how much, if any, is deductible. Other legal fees in connection with divorce that may save you taxes include costs to collect alimony payments (but not costs to resist collection). Also, if legal work is involved in getting marital assets, the part of fee allocable to the property can be added to its basis. This can save you tax when the property is disposed of.
Phil Shechter is a Certified Public Accountant (CPA) and senior partner at Berenfeld in Miami. He has been practicing accounting since 1982.