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Specialty tag(s): Divorce, Complex Property

Tax Implications of Divorce: Eight Common Issues to Consider When Negotiating Your Divorce Settlement

P. Lindley Bain | May 30, 2024

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During your divorce, you may be faced with various tax issues, and it is important that you understand these divorce tax implications before you start to negotiate your final settlement. If issues are discovered in your taxes after a divorce settlement has already been negotiated, resolving them post-settlement can add substantially to the cost of your divorce. Your divorce attorney can help you spot potential problems during the divorce, but tax advice is not something they’re qualified to offer. To obtain sound advice on how to handle divorce tax issues, it is important that you consult with a qualified expert, such as a certified public accountant or tax attorney, who is knowledgeable on the subject.

Here are some common divorce tax questions and situations that you should discuss with a qualified tax professional prior to reaching a final divorce settlement.

Status of Tax Return Filings for Each Year of Marriage

In a standard final divorce decree, the typical agreement is that for each year of the marriage, both parties share equal responsibility for any federal income tax liabilities and are each entitled to half of any federal income tax refunds accrued during those years. However, this “typical” agreement in a divorce, a tax refund split, does not work for everyone. It’s essential to determine whether you filed a federal income tax return for every year of your marriage, if you were audited during those years, and if you have any outstanding tax liabilities for any year of your marriage.

We recommend that you secure copies of all your federal income tax returns from each year of your marriage for at least the last seven years. If one spouse is a business owner or has complex investments, such as real estate, the likelihood of an audit could be greater than it is for a typical W-2 worker, and it’s possible that the Internal Revenue Service might find that you and your spouse owe taxes after divorce for a previous year of marriage. Before agreeing to the “typical” arrangement regarding taxes and divorce, discuss with your tax advisor the potential for being audited and the possibility of incurring tax liabilities for previous years of your marriage.

Filing Your Tax Return for the Year of Divorce

For the year when you officially divorce, you and your ex-spouse will file separate returns, since your marriage status is determined by what it is on the last day of the year. In Texas, you have two options for dealing with taxes during divorce for the months of the year that you are married.

  • Option 1: You partition income for the entire year, which means that you file as if you were unmarried for the entire year and claim only your deductions, withholding, and income. You do not claim any of your spouse’s deductions, withholding, or income.
  • Option 2: For the months of the year you were married, you claim half of your spouse’s deductions, withholding, and income and your spouse claims half of your deductions, withholding, and income.

There are many pros and cons for filing each way. The simplest way that provides for the least amount of contact and coordination with your ex-spouse is to partition income for the year of divorce. However, financially, this may not be the best option. We recommend you consult with your tax professional to understand the consequences of filing each way and determine the most appropriate method of filing for your situation. How you file your federal income tax return for the year of divorce MUST be set out in your divorce settlement.

If your divorce decree does not explicitly state that you are partitioning your income for the year of the divorce, your taxes should be filed using the second option by default, according to the IRS. Furthermore, you and your spouse might be eligible for deductions such as mortgage interest and property taxes, charitable contributions, or other deductions accrued during the portion of the year you were still married. It’s possible that one party may not qualify to itemize deductions based on their income, so it is crucial to determine if you would benefit from claiming all or some of these deductions for that period before you begin discussions. These itemized deductions from the year of the divorce should be addressed or divided in your divorce settlement.

Child-Related Deductions, Exemptions, and Claiming Head of Household as Divorced Parents

Under IRS guidelines regarding filing as head of household after divorce, a parent can claim head of household status for their child or children based on the number of nights the child is in their custody. IRS regulations also determine which parent is eligible to claim child-related deductions and exemptions. It’s crucial that you understand the rules and regulations concerning child-related deductions, exemptions, and filing as a divorced head of household before you enter into divorce settlement negotiations.

You can also make a contractual agreement that allows one parent the right to claim child-related deductions and exemptions. This provision can serve as an effective bargaining chip in negotiations, particularly if one parent gains minimal benefit from these deductions or cannot claim them due to high income. Therefore, it is essential to consult with your tax professional to understand how these deductions and exemptions will impact your post-divorce and to assess their monetary value for both you and your spouse. Calculating this financial advantage can be an instrumental strategy in finalizing your divorce settlement.

Alimony and Spousal Maintenance

As part of an agreed-upon divorce settlement, one party may agree to pay alimony or spousal maintenance to the other party. Alimony or spousal maintenance is a set amount of money that one party pays to the other party each month for a predetermined amount of time after the divorce. Under the current federal income tax laws, alimony or spousal maintenance is non-taxable, and the party paying the alimony or spousal maintenance does not receive a tax deduction. Spousal support or alimony is paid with after-tax dollars, just like child support is paid with after-tax dollars.

Tax Loss Carry-Forwards

A tax loss carry-forward occurs when a taxpayer reports a loss on their tax return up to seven years after the loss occurred. This reduces the tax liability during a year when income is high. A divorcing couple may have tax losses that they did not report on a prior return, which creates a potential asset to be divided in the divorce settlement. Your certified public accountant can tell you if you and your spouse have any tax loss carry-forwards. If so, these tax loss carry-forwards should be addressed and allocated in your divorce settlement.

The IRS has specific rules and regulations regarding tax loss carry-forwards, so it is important that your tax professional explains to you the options, whether you will be able to claim them in the future, and the potential financial benefit to either party. You will need this information BEFORE you start negotiating your final divorce settlement.

Tax Consequences of Liquidating Retirement Accounts

During the divorce, one or both parties may have taken funds out of retirement accounts or plans, which would subject both parties to a federal income tax liability. Find out if this occurred and the amount of the tax liability associated with early withdrawals from those accounts or plans from your CPA before you start final settlement negotiations. We recommend that you address this tax issue in the divorce settlement, specifically how it will be paid and who has to or can claim this income on their return.

As part of the divorce settlement, one party may be awarded all or a portion of the other party’s qualified or non-qualified retirement plan or account. The party who receives a portion of the other party’s retirement has a potential one-time option they may elect with respect to the portion awarded, providing the ability to liquidate those funds without a penalty but while paying federal income taxes on that amount. If you need liquid funds to pay off debt or to make the post-divorce transition, this could be a good option for you; however, know the tax consequences of liquidation prior to making that decision.

Tax Effects on Retirement Accounts

Monies in many qualified and non-qualified retirement accounts are before-tax dollars, which means that you contributed a portion of your earnings to those accounts without paying federal income taxes on those earnings at the time of the contribution. When you withdraw monies from those accounts at retirement, you will pay federal income taxes on that money as you withdraw it at your tax rate at that time. One thousand dollars of non-retirement cash in a savings account does not have the same value as $1,000 of cash in a retirement account, since one is after-tax dollars and the other is before-tax dollars. Therefore, in order to compare apples to apples when negotiating your divorce settlement, you should consider tax affecting the community property retirement accounts using a forecast tax rate of what your tax rate would be at the time of retirement. This exercise will help you achieve a more accurate picture of your estate and aid in your negotiations of the division of the community estate.

Other Tax Considerations in Negotiating a Divorce Settlement

Taxes can get more complex if one of you isn’t a typical W-2 employee. Many taxpayers, such as self-employed persons or members of a partnership, are required to make quarterly tax payments directly to the IRS instead of their employer withholding taxes from a paycheck. This means that four times each year, the taxpayer sends the IRS an estimated tax payment for that quarter. In negotiating a divorce settlement, it is important to know how much your spouse has paid to the IRS in quarterly tax payments to date for the current year and prior year. If a portion of these payments exceeded the actual liability for the tax year, they could be an asset of the community estate.

Before negotiating your divorce settlement, examine the actual investments (stocks and bonds) in any brokerage or investment accounts to determine an estimate of the cost basis of those investments. Some stocks may have had a large appreciation in value, and therefore, upon liquidation, you will pay short-term or long-term capital gains tax on the stock appreciation. You should consider the tax implications of those investments in light of your intended use of those funds. For example, if your goal is to liquidate funds to purchase a home, then agreeing to be awarded a brokerage account with large amounts of capital gains tax liability upon liquidation in lieu of requiring your spouse to do a refinance of the marital residence and pay you cash may not be in your best interest.

As you can see, taxes impact virtually every decision you will need to make in the divorce negotiation, and in high-net-worth divorces, taxes can represent a significant financial expenditure. Knowledge is power. Know the tax effects of your negotiations.

To learn more about taxes and divorce, please contact P. Lindley Bain at 512-454-8791.

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