Avoiding Tax Traps in Divorce
Tax law changes have made significant modifications to the tax treatment of dependents, alimony, child support, property settlements, and other divorce related issues which can produce unintended results for divorced individuals. Failure to understand these rules can be very costly.
Child Dependency Exemption
The custodial spouse is entitled to the outright exemption for the dependent child for any divorce or separation agreement granted since 1985. There are certain exceptions that allow the non-custodial spouse to claim the child exemption:
Beginning in 2005 non-custodial parents are entitled to the (child) dependency deduction as long as the couple's separation agreement stipulates the noncustodial parent entitlement. Prior law required the custodial parent to waive the deduction irrespective of settlement agreement terms.
- A multiple support agreement which designates the non-custodial parent to take the exemption.
- The custodial parent releases the exemption of the child(ren) to the non-custodial spouse.
- There is a pre-1985 divorce agreement, whereby a completely different set of rules and regulations are in effect.
- The Internal Revenue Service has taken the position that the custodial parent may release the exemption(s) in the divorce or separation agreement. As a result, custodial parents should take care to include in the agreement some protections against default or other limitations if they plan to agree to such a condition.
Child Care Tax Credit
If, under the terms of the divorce or separation agreement, you may not claim your child as a dependent, you are nevertheless entitled to the childcare tax credit. To be able to claim this credit these criteria must be met:
- You must file a separate return.
- Provide your home as the home of the qualifying child for more than half the year.
- Pay more than half the cost of keeping up your home for the year.
- Your spouse may not live in your house for the last six-months of the year.
Payments of alimony made under a decree of divorce or separation are deductible by the payor spouse and taxable to the payee spouse. In order to qualify as alimony, the payment must be in cash and cannot be a transfer of property or assets. There must also be a requirement that these payments will cease upon the death of the payee. If the individuals are either divorced or separated, they must not be living together when the cash payments are made. Single payments of cash may qualify as alimony if the amount is $15,000 or less. Payments exceeding $15,000 per year are subject to a recapture rule if they do not continue for 3 years or more unless ended because of the death of either spouse or the remarriage of the payee.
Any cash payments made to a third party, if required by the agreement on behalf of the payee spouse, will still qualify as alimony payments. Thus, payments made for rent, mortgage, tuition, or living expenses of the payee spouse under the terms of the divorce or separation instrument can qualify as alimony payments.
The agreement may also call for alimony (or property settlement) payments to be made from pension or retirement funds under a Qualified Domestic Relations Order (QUADRO). Payments made under a QUADRO are exempt from the 10% penalty on premature distributions from qualified retirement plans.
Disposition of Principal Residence
What happens to a jointly owned principal residence is usually a key item in a divorce agreement. The three most frequent provisions chosen are:
Recent tax changes make option two or three more favorable in view of the home sale capital gain exclusion rules.
- Sell the house and divide the proceeds with each spouse reporting his or her share of the sale on separate returns.
- Transfer the house to one spouse or the other.
- Retain joint ownership allowing the custodial parent to live in the home until the children reaching specific ages, etc.
Child support is neither taxable to the recipient nor deductible by the payor. If part of an alimony payment is based on a child’s situation (such as coming of age, marriage, and college), that portion of the payment is presumed to be non-deductible child support.
Alimony payments received by a payee are considered to be "earned income" for the purpose of allowing alimony recipients to contribute to an Individual Retirement Account. This is true even if the alimony recipient is not employed and, therefore, not earning wages.
Deductibility of Legal Fees
Legal fees paid in connection with obtaining a divorce are not deductible. Fees paid for obtaining and/or maintaining alimony or income producing property and for tax advice are deductible. In order to qualify as deductible legal fees, the attorney must stipulate, on the invoice, the amount or percentage of fees attributable to tax matters. Legal fees are miscellaneous itemized deductions subject to the 2% of AGI limitation. Fees allocated to capital assets increase the asset's cost basis and are recovered upon the sale of the asset.