Guest Writer: Danielle Lipari, CPA, MBA
It’s no secret that getting divorced financially impacts both parties in a number of different ways. From something as complicated as financing a new household to the simple act of the opening an individual checking account, maybe for the first time in years, divorce comes with a set of financial circumstances and considerations that may seem overwhelming. One such consideration is the obligation each party having to now file their own separate tax returns. You will be considered unmarried by the IRS in the year your divorce is finalized, and no longer be able to file a joint return from that tax year forward. A few key items should be kept in mind to ensure your understanding of the tax implications that a divorce may bring:
Prior to 2018, the payment of alimony was tax deductible for the payor and considered to be taxable income to the recipient. The Tax Cuts and Jobs Act of 2017 changed how the IRS treats alimony. It is no longer tax deductible for the payor and the recipient does not include alimony received as taxable income for federal tax purposes. We note, however, that the State of New Jersey does still consider the payment of alimony as deductible and the receipt of alimony as taxable income. This is a considerable change to the landscape of divorce and should be carefully considered when negotiating the terms of alimony.
- Filing Status and Dependents
As an individual, unmarried taxpayer, you have two options for your filing status: single or head of household. Filing as head of household only applies in cases where there are dependents (children) in the mix, and offers a higher standard deduction, $18,350 vs. the $12,200 for single filers. In order to claim the head of household, you must meet the following qualifications:
- You must be unmarried at the end of the tax year.
- You must have paid more than half the cost of keeping up a home for the tax year.
- Your dependent must have lived in that home for more than half the tax year. Keep in mind that an exception is made for children who are temporarily absent due to attending school away from home.
Only one parent is allowed to claim head of household status, even if the dependent(s) live with each parent an equal amount of time. In that case, the head of household status would fall to the parent with the higher adjusted gross income.
Claiming a dependent on your tax return used to give you an additional tax deduction for each dependent for filing purposes, however that has changed with the Tax Cuts and Jobs Act which eliminated all dependency exemptions. Certain tax credits and deductions are still available to those filers claiming dependents and should be considered when determining which spouse will claim the dependent(s). These tax credits include the child tax credit (up to $2,000 per qualifying child), the credit for childcare and dependent care expenses, the earned income tax credit and the American Opportunity tax credit for qualified education expenses. Keep in mind that these credits have income qualifications and phase-outs at certain income levels. For this reason, it is advisable to consult with a financial expert to ensure that these benefits are fully considered and realized when drafting your marital settlement agreement.
Keep in mind that although only one spouse may file for head of household status, the IRS has a special rule that allows the non-custodial parent to claim the child as a dependent in order to be able to take advantage of the child tax credit. This non-custodial parent would still file single, and the custodial parent would still be able to claim the child for purposes of filing head of household, as well as claiming the earned income credit and childcare credit. Again, it is imperative that these issues are clearly understood, negotiated, and included in the language of your final marital settlement agreement.
- Retirement Accounts
When splitting retirement accounts, it is important to understand the types of retirement plans being divided in order to determine any tax implications. IRAs are divided using a process called a “transfer incident to divorce”. The IRA account holder will not pay taxes on the transfer of funds, as these funds will be transferred or rolled over per your divorce agreement. The recipient will not pay taxes upon taking ownership of these funds; however, they will be responsible for any tax liability on any future distributions. Failure to clearly define the transfer of the IRA in the divorce agreement can result in taxes being owed by both parties. In addition, an early withdrawal penalty could be assessed on the amount received by the recipient if the recipient is under 59 ½ years old.
Qualified retirement plans, such as pensions, 401(k)s and 403(b)s are divided under a Qualified Domestic Relations Order, or QDRO. These mirror transfers incident to divorce as they too are tax-free transactions as long as the proper reporting by the plan’s administrator abides by the marital settlement agreement. The receiving spouse may roll the QDRO funds into another qualified plan or IRA. Any transfer from a qualified plan that is not deemed a QDRO by the IRS may be subject to tax and penalties. Consulting a financial expert can be helpful in assisting in the division of these assets.
- Dividing and Selling Homes
Oftentimes there is real estate to be considered in a divorce. Whether it is a primary residence or an investment property, there may tax implications for future sales that may result in monetary gains to the owner that should be accounted for in the settlement agreement. If you end up negotiating ownership of your primary residence, you will be able to exclude $250,000 of any capital gains from the future sale of a home as a single filer. If both spouses or former houses sell their home, they can exclude $500,000 if married filing jointly or $250,000 each if filing singly. Capital losses from the sale of primary residences are not tax deductible. Capital gains and losses from the sale of investment properties are reportable as taxable events and may be subject to capital gains tax in accordance with specific IRS rules. What is most important when receiving any real estate asset as part of your divorce is that you understand any possible future tax consequences when you are negotiating your settlement. If one party receives the home as part of the equitable distribution plan, that party will be responsible for all closing costs, including real estate commissions incurred, when he or she sells the home.
Make sure that you are able to clearly document the cost basis for any properties received in equitable distribution, including the purchase price, settlement costs and any improvements made.
Undergoing a divorce can feel like a complicated process when it comes to negotiating the financial matters. By understanding some of the key financial considerations and working closely with your attorney and financial expert, you can ensure that filing your taxes after a divorce will be as smooth a process as possible.
⭐️Danielle Lipari, CPA, MBA
Litigation & Valuation Services Group
Cowan, Gunteski & Co., P.A.