How Does a Divorce Affect Your Tax Bill?
Getting a divorce can be messy and include elements of uncertainty. Your tax liability does not have to be a surprise.
Below are some topics to discuss with your trusted tax advisors to help capture the full tax impact of your divorce.
- Property Settlements – Per Internal Revenue Code Section 1041(a), no gain or loss is recognized on a transfer between spouses or former spouses if incident to a divorce. There are specific rules to follow, so you may find yourself recognizing a gain/loss if you do not plan accordingly.
- For example: Transferring assets within one year after the date on which the marriage ceases is just one provision that allows for property transfers to occur without a gain or loss recognition. Former spouses should ensure they understand and follow IRS guidance to prevent income tax consequences.
- Also, the receiving spouse will have a carryover basis and holding period for the property received.
- Qualified Retirement Plans – A qualified domestic relations order (QDRO) allows the state court to allocate an interest in an employer’s qualified retirement plan to a former spouse.
- Qualified plans include defined benefit plans and defined contribution plans, such as profit-sharing plans, e.g., 401(k) and 403(b) plans, as well as employee stock ownership plans and money-purchase plans.
- Benefits distributed to Spouse 1 from the QDRO of Spouse 1 are taxed to Spouse 1 when received by that spouse (not subject to the 10 percent penalty) (rollover exemption).
- Payments made to the former spouse have no effect on the participant in the retirement plan.
- Individual Retirement Accounts – The transfer of an individual’s interest in an IRA to a spouse or former spouse pursuant to a decree of divorce is not a taxable event to either spouse.
- Savings Bonds – The transferor must pick up the interest income and pay the taxes associated with all previously unreported interest prior to the transfer. The receiving spouse will be responsible for all interest after the transfer and will have the basis in the bonds received increased by the interest included in the transferor’s income (Rev. Rule 87-112).
- Cost of Getting Divorced – Legal fees associated with the divorce are not deductible. Tax advice related to the divorce is nondeductible (until after 2025, under the current law). However, the costs associated with the property settlements, as a result of divorce, can be added to the property’s basis.
- Example: The cost of changing the deed to change the title to the residence (or on stocks) can be added to the basis of the residence (or stock).
- To determine and document the correct tax treatment of professional fees incurred during a divorce proceeding, all invoices should specify the amounts related to tax advice, the collection or production of income, or the defense of title to property. If the invoice provides no breakdown, the taxpayer should request a more detailed statement.
- Estimated Tax Payments – If you make joint estimated tax payments during the year and then later file separate returns, the payments made can be allocated fully to either spouse or divided between both tax returns. Both sides must agree. Due to delays at the IRS, it may be better to get the final overpayment refunded and have each spouse make payments under their own Social Security number, instead of relying on the IRS to properly allocate the estimated payments. If no agreement is reached, the payments are allocated based on the allocable shares of the combined income tax (including self-employment tax, if applicable). (See Janus v. United States, 557 F.2d 1268 (9th Cir. 1977) (applying allocation formula under pre-1984 TRA Reg. §1.6015(b)-1(b)); Morris v. Commissioner, T.C. Memo 1966-245)
- Tax attributes, such as net operating losses and passive activity losses, that are divided during divorce have differing and complex tax treatments. These attributes should be considered carefully with professional advisors to help ensure they are divided accurately and reported correctly prior to and after divorce.
- The tax liability from a previously filed joint tax return is the responsibility of both spouses. Even if the divorce decree states that one spouse will be responsible, if more taxes are owed due to an audit, both spouses are liable. The exception to this is to get Innocent Spouse Relief. (IRS Publication 971) Innocent Spouse Questions and Answers | Internal Revenue Service (irs.gov)
- Child-Related Benefits – Who gets to claim a child will have an impact on your taxes as well. There are many elements to keep in mind requiring whether either spouse can claim a child, and sometimes the facts trump the desires of the spouses. Some of the benefits to review include:
- Earned Income Tax Credit
- Child Tax Credit
- Additional Child Tax Credit
- Child and Dependent Care Credit
It is important to note that divorces can take multiple years and the year you finalize is the year of the applicable tax law for your divorce decree. It is important to communicate with your trusted advisor throughout your process and not just in the beginning or after the fact.