Tax Considerations In Divorce
Tax Liabilities
During a divorce, it's important to understand the typical tax liabilities that you and your spouse may face.
To begin with, if you and your spouse decide to sell your marital home as part of the divorce, you may have to pay capital gains tax on the profit from the sale. While single homeowners can exclude up to $250,000 of gain on their taxes, married homeowners filing jointly can exclude up to $500,000. However, this exclusion may not fully cover the gain from the sale, especially if the home has significantly appreciated in value.
Secondly, spousal support, or alimony, has tax implications. Under the Tax Cuts and Jobs Act of 2017, for divorce or separation agreements executed or modified after December 31, 2018, the spouse paying alimony can no longer deduct it, and the recipient spouse doesn't report it as income. This is a significant shift from past laws where the payer could deduct the alimony and the recipient would report it as taxable income.
Next, consider child support payments. Child support is not deductible for the person making payments and is not taxable income for the recipient. Thus, you won't need to report it on your taxes.
Division of assets, such as retirement accounts, can also have tax implications. For instance, early withdrawal from an individual retirement account (IRA) or 401(k) can lead to penalties and income tax. However, if these transfers are written correctly into the divorce decree and completed as part of a divorce settlement, these can often be done without the typical tax consequences.
Consider the tax status you will choose after your divorce. You can't file as "Married Filing Jointly" once your divorce is final. If you have dependent children, you may qualify to file as "Head of Household", which comes with tax advantages compared to filing as "Single".
Filing as Head of Household (HOH) rather than Single can provide significant tax advantages for those who qualify. HOH status offers larger standard deduction amounts and more favorable tax brackets compared to the Single filing status. For tax year 2022, the standard deduction for Single filers was $12,950, while HOH was $19,400. The tax rates for each income bracket are also generally lower for HOH filers, meaning that a larger portion of your income is taxed at a lower rate.
Divorcing parents have a few options when it comes to claiming minor children on their taxes. Only one parent can claim each child as a dependent for tax purposes. Typically, the custodial parent (the parent with whom the child spent the most nights during the tax year) is entitled to claim the child as a dependent. However, the custodial parent can relinquish this right to the noncustodial parent by submitting IRS Form 8332.
When deciding which parent should claim the child, there are a few things to consider. The tax benefit of claiming a child is primarily seen in the form of the Child Tax Credit, which as of 2022, is worth up to $2,000 fper qualifying child. This credit begins to phase out for individuals with an adjusted gross income of over $200,000 or $400,000 for married couples filing jointly. Therefore, if one parent earns significantly more than the other, it might be more advantageous for the lower-earning parent to claim the child.
When crafting a divorce agreement and parenting plan, you should consider the tax implications of different scenarios. These documents should clearly outline who will claim the child each year for tax purposes. It can be alternating years, or always one parent, or could be split if there are multiple children. It's important to work with a financial advisor or accountant during this process to understand the tax implications and ensure that the agreement is structured in the most beneficial way for all parties involved.
Tax laws can be complex and change frequently, so consulting a tax professional is a prudent step to fully understand your liabilities and potential deductions or credits you may be entitled to.
Tax Relief
Navigating tax liability during and after a divorce can be a complex task, but understanding the various relief provisions offered by the IRS can be beneficial. In cases where your spouse or former spouse failed to report income correctly, reported it improperly, or claimed improper deductions on a joint tax return, you may be eligible for what is known as "Innocent Spouse Relief". This provision can protect you from being held responsible for the tax liability resulting from these errors. For example, if your ex-spouse owned a business and understated the income, resulting in a significant tax debt, you could potentially be absolved from this responsibility if you can prove that you had no knowledge or reason to know of the discrepancy.
On the other hand, "Separation of Liability" provides a separate allocation of additional tax owed between you and your former spouse when an item wasn't reported correctly on a joint return. This means that you would only be responsible for the portion of the tax debt attributable to you. For instance, if an investment property jointly owned was sold and the capital gains were not reported correctly, the IRS may divide the tax liability between both parties.
In certain situations, you might qualify for "Equitable Relief". This provision applies when, under the given circumstances, it would be unfair to hold you liable for errors or underpayment of tax on a joint return. This consideration often takes into account abuse and financial control by the other party. So, if your former spouse controlled all financial matters, including tax filings, and you had no reasonable way to understand or rectify the situation, the IRS may grant equitable relief.
In any of these cases, you need to submit a form to the IRS within an allotted time period. Form 8857, Request for Innocent Spouse Relief, must be filed no later than two years after the date on which the IRS first attempted to collect the tax from you. It's also important to attach a detailed explanation of why you believe you qualify for relief. You can access Form 8857 and detailed instructions on the IRS website (https://www.irs.gov/forms-pubs/about-form-8857).
Remember, tax matters related to divorce can be complicated and it's beneficial to seek professional advice. Consulting a tax professional can help ensure you make well-informed decisions and avoid unnecessary liability.