Divorce is a challenging process that brings about substantial life changes. But how significantly does it impact your taxes? What is the tax side of divorce?
Navigating the fiscal landscape of divorce requires a strategic approach. Accordingly, this article offers clear, actionable insights to help you traverse the tax implications.
Read on to equip yourself with vital knowledge that will assist you in making informed decisions. The details below could mean the difference between financial hardship and stability.
The Tax Side of Divorce: Key Considerations for Financial Planning
The IRS categorizes taxpayers into five different filing statuses:
- Married Filing Jointly
- Married Filing Separately
- Head of Household
- Qualifying Widow(er) with Dependent Child
The date of your divorce can significantly affect your filing status. For example, your marital status depends on the last day of the tax year (December 31). If your divorce clears by then, the law considers you unmarried for the whole year. Hence, you cannot choose Married Filing Jointly or Married Filing Separately.
Instead, you would likely file as Single or Head of Household. However, if the divorce does not conclude by December 31, the IRS will consider you married for the tax year. The timing of the decree is critical, and taxpayers must understand its implications on their filing status to avoid potential penalties. This might be a reason that some couples begin with a legal separation and then proceed to divorce if they cannot work out their differences.
Division of Assets and Tax Implications
Most states use an equitable distribution method for divorces. This legal term means that assets divide fairly but not necessarily equally. The most crucial factors include the length of the marriage, age, health, and income potential, and any marital debts.
Alternatively, community property states consider marital assets joint property. As a result, they split equally among the spouses. This is often the reason people seek pre or post nuptial agreements. Even though 50/50 splits seems fair, it’s not always the case.
Furthermore, moving assets like real estate, stocks, or mutual funds can trigger capital gains taxes. The spouse who receives them must also consider the cost basis or original value. As a result, you must factor in stock splits, dividends, or return of capital distributions.
Retirement assets also have significant tax implications. Most people will want to use a qualified domestic relations order (QDRO) when they split a 401(k) or an IRA. This document allows transferring these assets under a divorce or separation agreement without taxation. A transfer or withdrawal without a QDRO could be a taxable distribution.
Alimony and Child Support
Alimony payments were tax-deductible before the Tax Cuts and Jobs Act of 2017. But divorces that finalize after December 31, 2018, are no longer eligible. Additionally, the recipient must report the payments as income. This change is substantial and can affect the net income of both parties.
On the other hand, child support has different tax considerations. The IRS does not consider these payments as income. Therefore, the receiver does not owe this financial support for income taxes.
Which parent can claim the child as a dependent is another critical element. Typically, this individual is the custodial parent. Regardless, the custodial parent can relinquish this right using IRS Form 8332.
Legal Fees and Tax Deductions
Spouses often have substantial legal fees as part of a divorce. Unfortunately, not all of these expenses are tax-deductible. Some taxpayers could deduct these costs before 2017, but this benefit does not apply through 2025.
One notable exception is that qualified retirement plan benefits can still count as deductions. The government considers them to count as recovering your income or property. Furthermore, business owners can potentially deduct attorney fees and court costs related to their business.
Tax Implications of Selling the Marital Home
Taxes apply to the profit from selling your marital home. The calculations involve the selling price minus the purchase price, adjusted for any substantial improvements. There is an exclusion available when the property was your primary residence. Generally, you can exclude $250,000 – $500,000 if you lived in the house for two of the previous five years.
A divorce changes these adjustments. For instance, a spouse who remains in the home and sells it later can only claim up to $250,000. But a sale, while married, qualifies for up to $500,000.
The details of the divorce can also affect this consideration. There could be an agreement that one spouse will remain in the home while the other pays the mortgage. As always, it is in your best interest to consult a lawyer or tax professional to understand the implications of your circumstances.
Consult a Local Divorce or Tax Lawyer
The tax side of divorce and the considerations above only scratch the surface of what you need to know. The financial changes after a divorce extend far beyond asset division, spousal support, legal fees, or selling a home.
Developing strategies to mitigate potential tax liabilities can provide valuable guidance and peace of mind. Navigating the tax landscape of divorce may seem daunting, but remember, you are not alone.