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8 Common Tax Issues to Consider When Negotiating Your Divorce Settlement

P. Lindley Bain | March 24, 2022

During your divorce, you may be faced with various tax issues, and it is important that you understand them before you start to negotiate your final divorce settlement. If tax issues are discovered after the 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 but is not qualified nor should they give you tax advice. 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. The following are common 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

The typical agreement in a final decree for divorce provides that for each year of marriage, both parties are equally responsible for any federal income tax liability, and both parties are entitled to one-half of any federal income tax refund for any year of marriage. However, the “typical” arrangement may not work for your situation. It is important that you find out if you have filed a federal income tax return for each year of marriage, whether you were audited any of those years, and whether you owe any tax liability for any year of marriage.

We also recommend that you obtain copies of all your federal income tax returns for each year of marriage, going back at least seven years. If one spouse owns his or her own business or has many complicated investments such as real estate investments, your potential for being audited may be higher than the average person W-2 employee. Therefore, the IRS may determine in the future that you and your spouse owe money for a prior year of marriage. You should discuss with your tax professional your risks of being audited for a prior year of marriage and your risks of owing a liability for any prior year of marriage before you agree to the “typical” arrangement.

Filing Your Tax Return for the Year of Divorce

For the year that you officially divorce, you will file a separate return since your marriage status for that year is determined by your marriage status on the last day of the year. In Texas, you have two options for dealing with months of that 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 income, deductions, and withholding and none of your spouse’s income, deductions, and withholding.

Option 2: For the months of the year you were married you claim one-half of your spouse’s income, withholding, and deductions and your spouse claims one-half of your income, withholding, and deductions.

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 best option. Therefore, we recommend you consult with your tax professional to understand the consequences of filing each way and to 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 there is no language in your divorce decree that specifically states you are partitioning income for the year of divorce, then the default per the IRS is the second option as stated above. Additionally, you and your spouse may have mortgage interest and property tax deductions, charitable deductions, or other deductions from the period of time that you were married during the year of divorce. One party may not be able to itemize deductions based upon their income so finding out whether you would benefit from taking all or part of these deductions for that period of time will be important for you to know prior to starting divorce settlement negotiations. You should divide or address these itemized deductions from the year of divorce in your divorce settlement.

Child Related Deductions, Exemptions, and Claiming Head of Household Status

By the rules and regulations of the Internal Revenue Service, a parent is entitled to claim head of household for the child or children based upon the number of nights they have possession of the child. The Internal Revenue Service’s rules and regulations also set out which parent or parents are entitled to claim child related deductions and exemptions. It is important you understand the rules and regulations for the child related deductions and exemptions to which you believe you are entitled or would be entitled prior to negotiating your divorce settlement.

You may contractually agree that one parent has the right to claim the child related deductions and exemptions. This ability may be a useful negotiating tool, especially if one parent does not benefit much from those deductions or exemptions or is unable to claim them because his or her income is too great. Therefore, it is imperative you understand, by consulting with your tax professional, how any child related deductions and exemptions will affect you after the divorce and to monetize that benefit for you and your spouse. Quantifying the monetized benefit can be a useful negotiation tool in negotiating your final 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 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 where 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 carryforwards. If so, these tax loss carryforwards should be addressed and allocated in your divorce settlement. The Internal Revenue Service has rules and regulations regarding tax loss carryforwards 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.. A potential option may include the ability to liquidate those funds without a penalty but 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 Effecting 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 one thousand dollars 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-effecting the community property retirement accounts using a forecasted 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

Many taxpayers, such as self-employed persons or members of a partnership, are required to make quarterly tax payments directly to the Internal Revenue Service instead of their employer withholding taxes from a paycheck.  This means that, four times each year, the taxpayer sends the Internal Revenue Service 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 Internal Revenue Service 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 (stock 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 gain tax liability upon liquidation in lieu of requiring your spouse to do a cash out 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, 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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