Don’t overlook this important element of divorce planning.
- While not typically top of mind during divorce, taxes are an important consideration, especially completing your tax return.
- Consult with an attorney or advisor who understands the tax laws so that planning can be done before you agree to a settlement.
- Being equipped with information regarding divorce and tax returns early on can help you work towards a reasonable divorce settlement agreement.
Divorce is emotionally and financially difficult and there are so many things for a divorcing couple to think about and work through. Taxes are not typically top-of-mind during this challenging time, but there are very important decisions that need to be made to ensure that tax returns are properly filed and tax liabilities are shared as required by state distribution laws.
It’s important to consult with an attorney or advisor who understands the tax laws so that planning can be done before you agree to a settlement. A tax attorney or tax accountant can review your divorce or separation agreement to determine the tax consequences of the agreement, and help plan so that you will not incur any current or deferred tax liabilities that you were unaware of when executing the divorce agreement. Your advisor will look at many tax issues from a technical standpoint but there are some basic things that will be helpful for you to know.
Change to your filing status
Once you are divorced or separated there will likely be a change to your filing status on your tax return. So what does that mean for you? Your filing status is used to determine a number of factors on your tax return, including, but not limited to, your tax rate. A taxpayer’s marital status on the last day of the tax year determines the filing status for that entire tax year. An individual will be considered to be divorced for the entire year if the divorce was finalized on or before December 31 of the tax year. A divorced individual is able to use the Single or Head of Household filing status for the tax year in which the divorce was finalized.
Going through a divorce can be a long process and in many cases a couple in the middle of a divorce is still married at the end of the tax year. Taxpayers not legally divorced or separated on December 31 are considered married for that tax year and will have the option to file their tax returns as Married Filing Jointly, Married Filing Separately, or Head of Household. The Married Filing Jointly status will usually result in a lower overall tax bill, but many individuals don’t want to have to work with their spouse to get the return filed, as there may be disagreement regarding many factors that impact the return. If you are in this situation, then your next best option is the Head of Household filing status. The Head of Household filing status is typically more advantageous than the Single or Married Filing Separately statuses if the taxpayer has a dependent child.
A taxpayer is able to file as Head of Household if the taxpayer is not married or is legally separated at the end of the tax year or the taxpayer did not live with his or her spouse for the last six months of the tax year. The taxpayer also has to have paid for more than one-half of the costs to maintain the household, and the taxpayer’s child(ren) must qualify as dependents and live with the taxpayer for more than one-half of the year. All of these rules probably seem overwhelming, but it’s important to know that you have options when trying to determine your filing status. Your tax advisor can work with you to determine the most advantageous filing status for your circumstances.
There are also considerations if you’ve been filing a return jointly with your spouse since you were married and you reported your income without having to determine what income belonged to each person. When divorcing, you need to figure that out so that each spouse reports the proper amount of income. Determining the proper allocation of income and deductions in the tax year a divorce is finalized or when a divorcing couple chooses to file separately is dependent on the distribution laws of the state where the divorce decree was or will be executed.Taxpayers in most community property states are required to equally split all community income up to the date of the divorce decree. After the divorce has been finalized, all income from that date through the end of the tax year is reported by the individual who earned it. Taxpayers divorcing in an equitable distribution state will report all income they personally earned and any income received from property they personally own.
Understanding taxation of spousal support payments
Spousal support payments are common in divorce settlements so it’s important to understand how these payments will impact your taxable income. Not all payments made from one spouse to another are considered alimony. In order for spousal support to qualify as alimony, the payments need to be made pursuant to a divorce decree or separation agreement. Payments must be made in cash, not property. The spouses may not live in the same household, they may not file a joint tax return, and there can be no requirement that payments be made to the payee after the death of the payee spouse. Prior to January 1, 2019, spousal support payments that qualified as alimony were taxable income to the payee and tax deductible to the payer.
However, the 2017 Tax Cuts and Jobs Act made significant changes to the taxation of alimony income and deductions. The effective date of the changes related to alimony was January 1, 2019. Any divorce or separation agreement instituted after that date will be governed by the new tax law, under which alimony income is not taxable to the recipient and the tax deduction for alimony paid is eliminated.The tax treatment of alimony for agreements entered into before January 1, 2019 will not change.
Deductibility of fees
Not only is divorce difficult, but it can be very expensive. It’s commonly asked whether or not any of the attorney or advisor fees incurred during a divorce are tax deductible. Unfortunately, the Tax Cuts and Jobs Act legislation repealed the deduction for legal and other professional fees for individual taxpayers. Until December 31, 2017, fees paid for tax planning and advice or to obtain taxable alimony were tax deductible. This provision of the law does sunset, meaning that as of January 1, 2026, the deduction for legal and professional fees will once again be allowed.
Don’t forget about overpayment options
There is another piece of information that is easy to overlook but has a big impact on the actual amount of tax paid. An overpayment on your prior year’s tax return that has been applied to next year’s estimated tax and estimated tax payments that have been paid during the tax year can be allocated between you and your spouse. The IRS allows taxpayers to allocate these payments in any agreed upon manner as long as an explanation for the allocation is attached to the tax return when it is filed. The distribution laws in your state may dictate the allocation of these payments. The payments will likely have to be allocated equally to each spouse if you are divorcing in a community property state and the tax payments were paid from community funds. The laws for equitable distribution states may require that any estimated tax payments be divided among spouses in proportion to each spouse’s separate tax liability.
All of these rules can be overwhelming. However, being equipped with information regarding divorce and taxes early on can go a long way in helping you navigate these tax issues with your advisor and work towards a reasonable divorce settlement agreement.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that, while this publication is not intended to provide tax advice, in the event that any information contained in this publication is construed to be tax advice, the information was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any matters addressed herein.Download Article