Divorce & Taxes: The 4 Things You Must Know
It’s tax season — that time of year when millions of Americans struggle through the endless paperwork, stress and strife of preparing tax returns. For those who are contemplating, in the midst of, or just out of a divorce, the difficulties of tax season pose an even greater challenge. The stakes are high and the penalties for mistakes are severe, making it critical that you avoid the traps and missteps that plague the world of tax and divorce.
With that in mind, and before you file your return, here are Four Things You Must Know About Divorce and Taxes:
1. The Key Difference Between Alimony and Child Support
Alimony (support paid from one spouse to another for the benefit of the receiving spouse), is different from child support (support paid from one spouse to another for the benefit of the child) in several ways, one of which is critical in tax season: alimony is tax deductible by the payer and child support is not.
Similarly, alimony is taxable income to the receiving spouse, while child support is not. When negotiating a divorce settlement, people sometimes (mistakenly) believe that alimony and child support dollars are equivalent, but their disparate tax treatment means they could not be more different.
2. The Tax Impact of Dividing Property
Thanks to §1041 of the Internal Revenue Code, the division of property in a divorce is not a taxable event. There is, however, a potentially huge tax impact hidden within: tax basis. Tax basis is, simply put, the price used to determine the capital gains tax when property is sold (usually the purchase price). While some property (such as cash) carries no capital gain when sold and other property (such as a residence owned by the taxpayer) has an exemption from capital gain up to a given dollar amount, many forms of investment will be hit with a capital gains tax when sold.
So, in a divorce settlement $250,000 worth of Apple stock is not worth the same as a $250,000 marital residence because the stock will be subject to capital gains tax when sold while the residence will not.
3. Understanding Your Filing Status
There are different filing statuses available (depending on certain factors) for those going through divorce: single, married, or head of household. Different statuses (as well as the decision whether to file jointly or separately with a spouse) may yield significantly different tax liabilities.
It is difficult to predict the precise impact of the different filing statuses and options without actually preparing multiple versions of a single year tax return to see which is most advantageous. While preparing multiple versions is an onerous task, it is also an investment of time which may yield hundreds or even thousands of dollars in tax savings.
4. Which of Your Divorce Attorney’s Fees Are Tax Deductible
Unfortunately, most of the fees paid to a divorce attorney are not tax deductible. There is, though, one loophole: §212 of the Internal Revenue Code allows that fees paid to a divorce attorney in the production or collection of gross income are tax deductible. While probably not all, or even most, of the fees you’ve paid will qualify under for this deduction, a knowledgeable divorce attorney will help you make sure you receive credit for every tax-deductible dollar you have paid.