Divorce is a common and sticky tax issue. We have provided examples of some questions from our fictional client couple, Jane and John Smith. The responses from their trusted advisor are in blue.
Jane and John are in the process of an amicable divorce and are already living separately. They do not have a prenuptial agreement (read more about prenuptial agreements) regarding the splitting of assets and have recognized that there is an inherent conflict of interest when one tax preparer advises the both of them. However, they have chosen to work together with the advisor they have used for years in order to proceed.
Jane is an attorney and the primary breadwinner for her family. John is a teacher by education, but has elected to stay home and care for the couple’s two children during their marriage.
1 – What makes payments to an estranged or former spouse “alimony”? Do we have to be divorced for the payments to be deductible by the payer and taxable to the recipient?
The Tax Cuts and Jobs Act (TCJA), signed into law in December of 2017, had specific provisions regarding alimony for divorces finalized after December 31st, 2018. For those agreements, alimony is no longer deductible by the payer nor taxable to the recipient.
Existing divorce or separation agreements won’t be affected unless the two parties decide to voluntarily apply the new rules and the document modification expressly provides for the treatment under new tax law.
The changes to the alimony deduction mean that the tax cost may go up for some in 2019 and others may not receive as much benefit as they may have in the past. You can read more about the tax cost of divorce under TCJA here.
Unlike most of the individual provisions in the Tax Cuts and Jobs Act, the alimony changes are permanent, or at least until Congress decides to change them.
2 – Is child support deductible by the payer and taxable to the recipient?
No, child support is neither deductible nor taxable.
3 – Do we have to be legally divorced to file as single?
Generally yes, except for the “Head of Household” exception noted where the parties have lived apart for more than six months, have provided more than half the support for the household, and have a dependent child. If you are still legally married on December 31st of the year, the only filing statuses available are “Married Filing Jointly” or “Married Filing Separate”.
However, if you are legally separated from your spouse under a divorce or separate maintenance decree you may also be eligible to file as single. State law governs whether you are married or legally separated under a divorce or separate maintenance decree.
If you are divorced on the last day of the year, you are considered unmarried for the entire year.
4 – On whose tax return would it be most beneficial to claim the children?
Taxpayers and their attorneys may set up provisions in their divorce decrees for alternate years or other arrangements related to claiming dependents for tax purposes.
Once a divorce is final, or spouses are no longer living in the same household for at least the last six months of the year, and at least one of the children has lived with a parent for the most number of nights and that parent has provided more than half the child’s support, then that parent is considered the custodial parent for TAX purposes. That parent may claim “Head of Household” filing status, even if the other parent has the right to claim the child due to the divorce decree. A Form 8332 must be completed for the noncustodial parent to have the right to claim the child, even if the arrangement is specifically denoted in the divorce decree.
Prior to the TCJA, it was often most beneficial financially for the party with the lower income to claim the children, as the one with the higher income would likely phase out of personal exemptions and child tax credits. The new tax law has eliminated personal exemptions, increased child credit amounts, added other family dependent credits, and widened the income window to allow more parents to benefit from credits. These, coupled with the fact that post-2018 divorce agreements will no longer have deductible/taxable alimony arrangements, may place extra emphasis or require additional analysis to determine an equitable arrangement. These provisions are slated to sunset in 2025, which means those that divorce and have small children may want to consider future years as well as current tax situations.
5 – We now have 2 primary homes (I live in one and John lives in the other) and 1 secondary/vacation home that we share. We have been informed by another tax advisor that even if we continue to file as Married Filing Jointly, we will be able to claim mortgage interest deductions on all 3 homes while we are filing jointly (1 primary for me, 1 primary for John and 1 secondary for us both). Is this correct?
No – only 2 homes may have mortgage interest deducted, and then only mortgage interest on up to $1 million worth of the home acquisition loans, down from $1.1 million prior to TCJA’s implementation. Real estate taxes can still be deducted, however the new law has limited real estate taxes, the state and local income tax deduction, and personal property tax deductions to $10,000 combined.
If the vacation home is used as a rental property, the income and expenses for that property should be reported and deducted as such.
If you file as “Married Filing Separately,” each person should claim the mortgage interest and real estate taxes they alone paid, or if consented in writing, one spouse may claim both homes.
6 – Currently our 2 primary homes and the secondary home are all deeded and mortgaged in both our names. Eventually, John and I would like to have each primary home deeded and mortgaged solely in the name of the person who lives there. Are there any tax implications of changing those names? What if we were to sell one of those homes in the future?
This would be a division of assets in your divorce decree. You’ll need to determine value, who will care/pay for the home, etc. Once the homes are deeded to the individuals, the deeded individual is the sole owner. There should be no tax implication in the transfer of assets pursuant to divorce. There may be tax implications to each individual, for example: if Jane were to sell stocks to pay John for his portion of the equity in the former martial home. The stock sale would result in some tax implications for Jane; however, there should be no need for John to recognize any gain from the home equity buyout.
If the home is sold in the future to a third-party after one spouse buys out the other’s interest, capital gains tax will apply to that sale. If the current owner meets principal residence selling rules (known as Section 121 exclusion), then the first $250,000 of gain will be excludable from tax.
If the spouses remain co-owners and only one continues to live in the home, it is important that the divorce or separate maintenance decree document the agreement that one spouse will stay in the home and the other to remain as co-owner pursuant to the divorce settlement. This will assist the preservation of both owners’ ability to take the Section 121 exclusion of $250,000 each. Otherwise, the nonresident co-owner may not be eligible for the exclusion and, therefore, would be required to pay tax on any capital gains.
7 – What expenses are tax deductible from our separation/divorce proceedings and attorney/advisor fees?
None. With TCJA in place, miscellaneous itemized deductions subject to a 2% threshold no longer exist. Previously, the only fees that were deductible pursuant to a divorce were those related to tax advice or income.
8 – We are planning to divest my 401(k) of at least half, possibly more, and give the funds to John upon divorce. All of it is currently in stocks or mutual funds. Do we need to sell these securities first and then transfer them, or can we transfer the stocks to him outright? And since John does not have his own 401(k) set up, will we have to pay tax or a penalty to transfer these securities/cash-if-sold?
Wait until the information is final and included in the divorce decree. Division of a retirement plan must be done via a qualified domestic relations order (QDRO). Your attorney should be familiar with this. John should be able to set up an IRA and have the funds rolled into it on his behalf. Transfers incident to a divorce in this manner should be a tax-free event, as long as the funds are not cashed out and a direct or trustee-to-trustee transfer is made. It will depend on the retirement plan if assets must be sold before transfer.
9 – What other tax implications are we not thinking of (i.e., tax benefits/penalties that we will lose or incur once we file as single)? For example, roll-over from our previous large stock loss, 529 college savings and gift tax returns, IRAs, etc.
Stock losses follow the owner and they are split 50/50 if there is joint ownership. Children’s 529 accounts follow the account owners, as do the IRAs and retirement accounts after all assets are split. Gift tax returns are individual returns and follow the individuals.
Another important item, which may or may not have eventual tax implications, is the updating of beneficiary information. Wills, estate plans, trust instruments, insurance and retirement plan beneficiary information all will likely require updates as a result of the change in marital status. It is not uncommon for this information to be neglected during this stressful time and can unfortunately have unintended consequences if a former spouse passes away without making the appropriate updates.
There are many scenarios, exceptions, and items specific to each couple. In addition, if you live in a community property state, some or all of these rules may not apply. Please be sure to speak to your attorney and contact us if we can help with your planning needs.
Erin Kidd is the Tax Individual Practice Supervisor at Thompson Greenspon and has nearly a decade of tax experience specializing in individual taxation. Throughout her career, she has focused on simplifying complex tax issues and educating clients to maximize their tax benefits and plan for future events. Erin is responsible for the review of individual Federal and multi-state tax returns, managing the firm’s Military Spouse Remote Preparer Program, preparation of individual tax returns with international taxation and reporting requirements, and assisting with the resolution of client issues with Federal and State Taxing Authorities.
Erin holds a Bachelor’s and Master’s Degree in Business Administration from Morehead State University, is an Enrolled Agent, a federally licensed tax preparer who has unlimited rights to practice before the IRS, and an Accredited Financial Counselor ®. She has been recognized by the Garrison Commands of West Point, NY and Fort Leavenworth, KS for her contributions to the military community for her work with the installations’ Volunteer Income Tax Assistance Centers