How Uncle Sam Impacts Your Divorce -- Tax Implications When You Split

By Suzanne Griffiths and Culver Van Der Jagt

Maintenance/Alimony Tax Deduction

Uncle Sam allows the payor to deduct maintenance payments from taxable income provided that the payment is made in cash and: 1) it is received by (or on behalf of) a spouse under a divorce or separation instrument, 2) the payment is not designated as payable but not includable in gross income, 3) the payor and payee spouse are not members of the same household at the time the payment is made, and 4) there is no liability for payment after the death of the payee and no liability to make a payment as a substitute for payments after death.

This provides considerable relief for the payor because the government allows the lower income earner to share the tax burden at a lower overall tax rate. Where there are minor children in a divorce case, the maintenance payments can also reduce the payor’s child support obligation, which may result in an overall saving in real terms of close to 50 percent of the actual maintenance payment made. There are tax traps involved in frontloading maintenance payments or having them linked to a contingency related to the children’s emancipation, and tax advice is required when finalizing the agreements.

Property Division

Generally, transfers of property incident to a divorce are free of taxes.

The Family Home

If a residence has been used by the owner as his/her principal residence for at least two of the past five years, then the first $250,000 of capital gain for a single person, or $500,000 for most married couples who file joint income tax returns, is excluded from income. There is no reinvestment requirement for these tax-exempt gains and the exclusion is not a one-time benefit. Subject to certain restrictions, the benefit is generally available every two years. Furthermore, if a sale of a principal residence occurs within the two-year restriction and the primary reason for that sale relates to health, new employment, or unforeseen circumstances such as a natural disaster or divorce, a partial exclusion may still be available. Therefore, the equity in your home is probably worth more dollar-for-dollar than an “equivalent” amount of equity in stock that has built-in gains.

Stocks and Mutual Funds

As a rule, capital gains on stocks are simple. Your basis in stock, generally speaking, is the price at which you acquired the stock. The capital gains and losses are taxed at your ordinary income tax rate (for stock held less than a year), or 15 percent for stock held more than a year. This does not include state taxes at 4.63 percent. That means that the equity in the appreciated stock that you hold outside of retirement plans is generally worth at least 19.63 percent less in a divorce than equivalent assets in a money market account. Courts do not factor the potential tax liabilities into the divorce orders unless you can show that the stock is being sold. Otherwise it’s considered too speculative. Be aware that not all assets are equal once you factor in the tax consequences and you need to take that into account in your property division.

Rental Property

The assets that can be most affected when compared with cash in a divorce are real estate investments. Rental real estate is considered a depreciable asset under the Internal Revenue Code. That means that each year, you are entitled to depreciate the asset to counter your income. While this may have benefited you in the past, it certainly will not in a divorce, since upon the sale of such property, depreciation recapture tax must be paid. The calculation is difficult, but in effect, depreciation causes your basis in the rental property to decrease over time and significantly increases the amount of tax that you will be required to pay upon sale of the property. The bottom line is that the equity you have in your rental property, depending on how long you have held it, is probably worth significantly less than the equity you have in stock or your home. In addition, Colorado divorce courts will not take into account any costs of sales, including realtors’ commissions, taxes, or fees, unless the property is actually being sold.

Business Investments

The relationships between you and government administrators, suppliers, and your clients have a value that is appraised in a divorce. Despite the fact that all of that separately appraised “goodwill value” could equal zero if you die tomorrow, it is measured as an asset and divided equitably between you and your spouse. Colorado courts usually give the business owner all of the goodwill and give the spouse its value in other assets (or a note secured by the business interest). In general, the courts do not take into account the taxes payable on the sale of the business unless it is actually being sold. That may mean that one party is awarded the house with no taxes payable upon sale while the other receives a business, which has significant tax implications on sale.

Tax Filing Status

Generally speaking, a person’s tax filing status is determined as of the last day of the tax year. It can be determined as of other days during the tax year if you happen to have died before year’s end, but for purposes of people who are reading this article (no matter how bad your marriage might be) we’ll just assume you are in the category of people whose tax filing status is determined as of the last day of the tax year.

Head of Household

It is acceptable to file as Head of Household when the taxpayer is not married at the end of the year or when the filer files a separate return and the other spouse did not live in the same abode during the last 6 months of the tax year. Head of Household tax filing status may be used only if the taxpayer paid more than half of the costs of keeping up his or her home during that tax year, the home was the principal residence of that taxpayer’s qualifying dependent for more than half of that tax year, and the taxpayer is a U.S. citizen or legal resident for the duration of the entire year. Since 2005, an adult child must be classified as a dependent before the parent can claim Head of Household status. Only the taxpayer who claims the Head of Household status is entitled to claim the dependent care credits.

Joint Returns

Certain tax benefits are only available to married couples that file jointly. For example, the earned income credit and child tax credit cannot be claimed for a married couple unless they file jointly.

Married Filing Separately

The important thing to remember about Married Filing Separate tax returns is that they can be amended into Married Filing Joint tax returns. The opposite, however, is not true. A joint return, once filed, can only be amended by another joint return.

Single Status

Single status can only be utilized for unmarried persons and for persons who are divorced by year’s end.

Dependency Exemptions

An interesting fact regarding the dependency exemption is that there is a citizenship test for the dependent. The dependent being claimed must be a U.S. citizen, a U.S. resident or national of Canada or Mexico. Also, no dependency exemption may ever be claimed for a dependent who files a joint tax return. Only the parent who may claim the dependency exemption is entitled to take the child tax credit, the Hope and Lifetime learning credits, and the deduction for “Qualified Tuition and Related Expenses.”

Qualifying Child

To determine whether a child is a “qualifying child” for the child tax credit, the child must pass the “relationship test.” In essence, the child that is being claimed must be the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, or stepsister, or a descendant of that individual. Furthermore, as noted above, the
child has to pass the residency test, by having lived in the abode of the taxpayer for more than half the year. A child must be under the age of 19 to be a “qualifying child” for purposes of allowing a taxpayer to claim this credit, with the notable exception that if the child is a “full-time student” (a student who is full-time for at least 5 months out of the year) they must be under the age of 24. A qualifying child for purposes of the “dependent care credit” must be under the age of 13. Any child who provides more than 50 percent of his or her own support is not considered a “qualifying child.”

Conclusion

If, during your divorce, your spouse gets the equity in the family home and you wind up with “the same” amount of equity in the rental properties you own, while you each split stocks having a different tax basis, you may not be getting a fair deal at all. In fact, it is highly likely that you are getting far less than your spouse in real terms. Many assets are treated differently by the divorce courts in Colorado than they are in real after-tax terms. If you are thinking about divorce, you need to be aware of these differences, so that you don’t come out with an unfair settlement. Furthermore, if you are getting a divorce, you need to take a serious look at which filing status benefits you the most. You need to look at the requirements for the various exemptions and credits and you should be cognizant of how each decision will affect your tax filing. There are many tax considerations to take into account in a divorce and this article simply scratches the surface. A CPA and/or a tax attorney should be consulted for legal advice in complex divorce cases.