Tax Tips and Traps in Divorce
Here are two topics you’d probably rather not think about: divorce and taxes. If you’re separated or newly divorced, however, it could be worth your while to get some good financial advice about both.
Spousal SupportAlso known in some areas as "alimony" or "maintenance", spousal support is typically treated as taxable income to the person receiving it and tax-deductible for the person paying it. Before deciding whether a specific amount is going to work, you need to know what the actual out-of-pocket cost is if you're the payor or the net amount that you'll receive if you're the payee. For example, if paying $30,000 in spousal support annually, how much is that $30,000 going to cost you after factoring in the tax deduction? And, if you're receiving the $30,000, how much of that will you have to pay in taxes? For payments to qualify as spousal support, they must meet a number of requirements; make sure you've met them all.
Child SupportGenerally speaking, child support is non-taxable income to the person receiving it and it is not tax-deductible by the person paying it. If you're going to be paying both spousal and child support, you may be tempted to lump both payments together and call them "spousal support" so you can claim a bigger tax deduction. Sorry to burst your bubble, but the IRS and CRA are wise to this "strategy", which could land you in serious hot water! You can also end up owing back taxes, penalties, and interest if your support payments are not structured correctly in your divorce agreement. In the US, if spousal support is reduced or terminated because of a contingency related to a child (such as a child attaining a specific age or income level, dying, marrying, leaving school, or gaining employment), it can be reclassified as child support. There are many other ways the IRS could reclassify some or all of the deductible spousal support you have paid as non-deductible child support; make sure your agreement doesn't contain one of these hidden traps before you sign it.
Third-party PaymentsUsually, payments must be made directly to the recipient to be classified as support. But what if you're going to be paying child or spousal support to an ex who has a genuine problem with money -- a gambling addiction, for instance? "Third-party or specific-purpose payments can be considered support payments [under certain circumstances]," says Mary Krauel (CPA®, CA, MBA, CDFA®), who practices in Mississauga and London, Ontario. "Specific-purpose payments may include rent, property taxes, insurance premiums, and educational or medical expenses for the benefit of the recipient." This is helpful in settlements where there is concern the support payments will be used by the recipient for necessary expenses while at the same time preserving the deductibility for the payor, she adds. "To guarantee deductibility -- clearly state it in the agreement."
Divorce-related FeesIn the US, you can deduct the portion of fees paid to divorce-industry professionals (e.g., lawyers, actuaries, accountants, or appraisers) for tax advice or for help in getting spousal support. In Canada, you can deduct legal fees paid to establish, increase, or collect support payments; however, only the recipient of support may claim these deductions -- not the payor. "There is an inequity in the deductibility of legal fees paid by the recipient of support payments versus the payor," points out Karen Archibald (CDFA®, CGA, MBA, and Mediator), who practices in Truro, Nova Scotia. "This inequity is exacerbated by the fact that often it is the payor of the spousal support who would benefit more from being able to deduct legal fees as that person is most often in the higher tax bracket." Find out if you can deduct any of the divorce-related professional fees before you file your taxes.
Filing Status"Filing status is often more important than dependency exemptions: someone filing as a Head of Household (HOH) can claim a higher standard deduction and lower tax rates than a single filer," says Heather Smith Linton (CPA®, CFP, CVA, CDFA®), who practices in Durham, North Carolina. "This can often translate into more of a tax savings than a dependency deduction. A couple needs to have at least two children to make this strategy work," she continues. "The general rule for filing as HOH is that an unmarried taxpayer would have to maintain a household that is the principal place of abode for over half the year for a qualifying child." According to Justin Reckers (CFP, CDFA®), who practices in San Diego, California, the HOH filing status strategy is a simple and elegant way to reduce overall tax bills and even has some other benefits. "HOH filing status comes with tax brackets identical to those available to the Married Filing Jointly scenario, but also allows for each party to the divorce to file separate tax returns," he says. Inquire about the requirements for claiming HOH to see if this strategy can work for you.
Joint Tax ReturnsIf you are still filing joint returns with your spouse, make sure to review your tax return before signing on the dotted line. "Remember -- you will be held liable for what is being reported, whether your spouse or a professional accountant prepared the form," warns Carlton R. Marcyan (JD, MBA, CPA®, CFP, CDFA®), a partner at Schiller DuCanto & Fleck in Chicago, Illinois. "In my nearly 25 years of practicing law, I would estimate that two out of three spouses do not look at their tax returns before signing and are not aware of what they are consenting to."
Tax Credits and BenefitsMake sure you're taking advantage of all possible tax credits and benefits during and after divorce; if your agreement isn't structured correctly, you may be unable to claim tax relief. Karen Hallson-Kundel (CGA, CBV, CDFA®), who practices in Winnipeg, Manitoba, points out that the separation agreement must specifically identify the parent who will claim the child in order to preserve the Eligible Dependant tax credit, for instance. "Families with two children can structure the separation agreement to indicate that each parent claims one child, effectively doubling the tax benefit," she says. "Carefully planning this aspect of a separation agreement can save your family between $4,052 and $6,702 (depending on your province) for the 2012 tax year." Terry Hawes (MBA, CGA, CFE, CDFA®), who practices in Port Moody, BC, adds that: "The Eligible Dependant Amount has specific caveats that must be met to qualify. This tax credit is often missed as practitioners and clients believe that these conditions must exist for the entire year since separation or as at December 31. In fact, the legislation states, ‘at any time in the year'. This strategy is often available in the year of separation to multiply the tax credit." In the year of separation, get your CDFA® or accountant to crunch the numbers to see whether you should be claiming the spousal support or any allowable tax credits. "If you pay support and you are were separated for only part of the year, you may claim either the deductible support paid that year or allowable refundable tax credits -- whichever yields the larger benefit," says Karen Archibald. "For example, Sally and Joe separated on September 1, and Joe pays Sally $300 each month in deductible support. Joe would be far better off claiming the spousal credit of $10,527 versus the support of $1,200." Of course, there are different tax credits and benefits in the USA and Canada, so find out what is available in your area and for your situation. Please consult your Certified Divorce Financial Analyst®, accountant, and/or family lawyer for specific guidance since each case and each state or province may have different requirements.
Diana Shepherd (CDFA®) is the Co-Founder of Divorce Magazine and the former Director of Marketing for the Institute for Divorce Financial Analysts.