Divorce is bad enough without having to deal with tax issues as well! But not understanding the tax consequences of your divorce agreement can cost you, big-time. Watch this video before you sign those papers.
Video produced by Black Butterfly Productions
Hi, my name is Amy Wall. I'm an Enrolled Agent, a federally licensed tax practitioner. Today I'm going to talk about divorce and taxes. I was divorced myself about 10 years ago so I am intimately familiar with that particular slice of hell. As difficult as this time is, there are still tax considerations that you need to know about before you sign those papers.
The four topics I'm going to cover today are: filing status, dependents, spousal maintenance vs. child support, and division of assets. In tax world there are five different filing statuses: single, married filing jointly, married filing separately, head of household and qualifying widow or widower. Now unless things are going horribly wrong with this divorce, you are not a widow or widower, so we’ll talk about the other four.
Let's start with single. The filing status of single is for single people! If you are legally married, you are not single no matter how long you haven't lived with that person. If you are legally married, you going to file either married filing separately or married filing jointly. Head of household is a little bit of a weird filing status. The original concept of head of household was a single parent with a child. It has since evolved a little bit from that. In the context of divorce, you could be unmarried with a child, in which case you're not single, you’re head of household. There's also a special qualification called “considered unmarried”. You know nothing in tax world is simple!
“Considered unmarried” means you are technically married but you haven't lived with that person for the last six months of the year and you have a qualifying dependent. July 1st is the magic date. If you're still living with that person on July 1st and you're married at the end of the year then you are not “considered unmarried” and head of household is not an option for you. Let me add that the filing status depends on your marital status on the last day of the year. You could have been married 364 days of the year and your divorce is final December 31st. Guess what? You are not considered to be married. So it's not something that's prorated or anything like that. December 31st is the magic day.
So why is filing status such a big deal? Why should we care so much about it? I have a little slide here for you to look at. What you see is the taxes that are paid for taxable income of $30,000, $60,000, $75,000 and $90,000 with the four different filing status. What you see is that married filing jointly pays a lot less tax than the other three filing status, followed by head of household. Single and married filing separate have the same amount of tax until we get into the higher income brackets. Married filing jointly is usually but not always is usually the best bet. What I do is I run the scenarios for my clients to see what's going to work best for them, married filing jointly vs married filing separately. If married filing jointly saves us all money, then we figure out how to make it fair between the two parties.
The other reason filing status matters is that the standard deduction changes dramatically from filing status to filing status. The standard deduction is the amount of income that is tax free if you don't itemize, so a large standard deduction can make a really big difference in your taxes. You see on the slide that married filing jointly has a standard deduction of twice that of single or married filing separately; head of household is somewhere in between. So head of household, if you qualify for it, is obviously worth pursuing.
So why would anyone in their right minds file married filing separately, given that married filing jointly is such a better deal? There are very good reasons why you may want to file married filing separately. Remember that when you sign a tax return you are attesting to the validity of the tax return and you are agreeing that you owe these taxes. Depending on your situation, you may or may not want to share that responsibility with your soon-to-be ex-spouse. Your divorce attorney may tell you that it’s no problem, we’ll just write in the divorce decree that the other person is going to half and you're going to pay half. But guess what? The IRS doesn't care what your divorce decree says. The IRS answers to a higher authority, as the saying goes. So if you owe $10,000 and your divorce decree says you’re going to split it in half, and you pay your share and he doesn't pay his share or vice versa, the IRS is going to come after you for the unpaid balance. You can say that it's not fair, that you paid your share, but that is not the issue. The technical term is that you are jointly and individually liable for these taxes.
Now we're going to talk about dependents. When there are kids involved in divorce, things get a little more complex. We get into the issue of the custodial parent versus the non-custodial parent. The IRS says that the parent with whom the kids spend 50% or more of their time is the custodial parent and they get the tax goodies. However, in a divorce situation, the custodial parent can give some (but not all) of those tax goodies to the non-custodial parent. Let's take a look at what tax breaks there are, what can be given away and what cannot. For the custodial parent: the head of household filing status (as we saw earlier that's a big deal), the earned income tax credit, the dependent care tax credit, tax free dependent care assistance if it's offered by your employer. These are only for the custodial parent and cannot be given to the non-custodial parent. What can be given to the non-custodial parent is the exemption (worth $4,000 in 2015), the child tax credit (worth up to $1,000 for a child under 17), and the education tax credits go along with whoever claims that child as a dependent. Both parents, custodial and non-custodial, get to claim itemized medical expenses. So if you pay medical expenses for your child you get to deduct those on your itemized on Schedule A whether or not you claim that child as a dependent. Tax free health care benefits provided by your employer can go to the custodial and non-custodial parent. Finally, HSA distributions qualify for their non-taxable status for a child whether or not you claim the child as a dependent.
Next: spousal maintenance vs child support. This is a really hot issue when you're going through a divorce and there are children involved. The reason for that is pretty straightforward. Spousal maintenance, which we used to call alimony back in the day, is deductible for the person paying it and it is taxable income for the person receiving it. Child support, on the other hand, is tax neutral. It is neither deductible nor does it count as taxable income. So it becomes pretty clear pretty early on that the person making the payments would like it to be spousal maintenance and the person receiving the payments would like it to be child support! For the payments to qualify as spousal maintenance there are certain characteristics that these payments must have. The payments must be in cash or check not property; the payments must end with the death of the recipient; the payments may not be disguised property settlement or disguised child support (and the IRS does have its ways of finding that out); spouses may not be members of the same household; the settlement agreement must not state that the payments are not spousal maintenance; the spouses may not file a joint return. An interesting thing about spousal maintenance is that it does count as earned income for IRA contributions but unfortunately does not count as earned income for the earned income tax credit. You may feel like you really did earn this income and I get it, but the IRS doesn't see it that way.
Next let's talk about assets. Often when we're dividing assets, there are assets that look equal but actually are not equal when it comes to the tax treatment of those assets. Here's an example. ABC stock worth $10,000 and originally cost $8,000; that means there's going to be a gain of two thousand dollars taxable upon sale. DEF stock worth $10,000 originally cost $1000, so that's a gain of nine thousand dollars taxable upon sale. So these are assets that look like they're worth the same but they're really not.
There are a lot of other issues on divorce and taxation! I'd be happy to meet with you for a free half hour consultation. Thanks for listening!
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