Taxpayers are met with a host of tax-related issues to resolve when they choose to separate or divorce. If you are contemplating separation or divorce, consult with a professional before finalizing any agreements, as failure to consider the complex tax issues surrounding these major life choices can have a long-term financial impact. The following articles discuss some of the frequently encountered issues.
Filing Status for Separated or Divorcing Taxpayers
Filing status for a tax year is determined on the last day of the tax year. If the taxpayers were married on the last day of the tax year, even if they were in the process of divorce, they have the following filing alternatives:
Alimony payments are made to a separated or ex-spouse as part of a divorce or separation agreement. Alimony is taxable to the recipient and deductible by the payer but only if spouses file separately. There are two ways to define alimony: one for payments under decrees and agreements dated after 1984 and another for payments under decrees and agreements made before 1985. This article deals only decrees and agreements after 1984.
– Must be required by a decree or instrument incident to divorce, a written separation agreement, or a support decree
– Must be in cash and must be paid to the spouse, ex-spouse, or a third party on behalf of a spouse or ex-spouse
– Is valid only if the taxpayers live apart after the decree
– May not be designated as child support
– Cannot be contingent on the status of a child
– Aren’t necessarily based on the marital relationship or intended for support of the ex-spouse
– End on the death of the payee
Alimony payments must be included in the recipient’s taxable income. The payee may deduct the payments as an adjustment to their AGI and must also include both the recipient’s name and SSN.
Community Property and Divorce
In community property states, community income has to be divided between spouses in the event of a divorce. Married taxpayers in the following states are subject to community property rules: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. State law determines when a spouse begins receiving separate income.
Community property rules don’t apply to an item of community income, and a taxpayer must report it if:
– The taxpayer treats the item as if only he/she was entitled to it, AND
– The taxpayer doesn’t let his/her spouse know the nature and amount of the income by the extended due date of the tax return in question.
A taxpayer will not be held responsible for reporting an item of community income provided that all of the following apply:
– The taxpayer doesn’t file a joint return
– No item of community income is included on the separate return,
– The taxpayer didn’t know of the community income
– Based on the circumstances, it wouldn’t be fair for the taxpayer to include the community income on his/her return
Dependency Exception for Children of Divorced or Separated Parents
Which parent may claim a child as a dependent?
Basic Rule: The custodial parent, or the parent with whom the child resides for the greater number of nights during the year, claims the dependent. The only way the non-custodial parent may claim a child as a dependent is if they qualify under one of the exceptions below.
Exceptions: The non-custodial parent can claim the exemption under the following exceptions:
– The custodial parent signs a statement assigning the dependency to the other parent. The exemption release can cover a single year, a number of specific years, or all future years, so exercise caution when signing over exemptions to the other parent for multiple years. If there is any doubt, contact a professional.
– The child’s dependency exemption is determined under a multiple support agreement where a group of taxpayers provide the dependent’s support and agree among themselves who is to claim the dependency.
There are other and more complex qualifications. Please contact us for assistance.
Head of Household
Married individuals can choose this status to file individually if they lived apart from their spouse at least the last six months of the year, and they maintained a home for themselves and their dependent child or stepchild for more than half the year paid more than half the cost of that home.
Injured Spouse Relief
If a taxpayer’s spouse has failed to pay child or spousal support payments, the refund on a joint return may be used to pay the spouse. To qualify as an injured spouse, taxpayers:
– Must not be required to pay the past-due amount
– Must have received and reported income on the joint return
– Must have made and reported tax payments (estimated payments or withholding) on the joint return
The above is simply a brief overview of some very complicated tax law provisions. Qualifying and filing for relief under these provisions requires the assistance of a professional.
Innocent Spouse Relief
To qualify for innocent spouse relief, the taxpayer must:
– have filed joint return with an “understatement” of “erroneous items” of his/her spouse
– establish that at the time the taxpayer signed the joint return, he/she didn’t know (and had no reason to know) that there was an understatement of tax
– It would be unfair to hold taxpayer liable for the understatement of tax
Joint & Individual Liability
When married taxpayers file jointly, they become jointly and individually liable for the tax and interest or penalty due on their returns, even if they later divorce and their divorce decree states that a former spouse is responsible for those amounts. This means one spouse may be held responsible for all the tax due, even if the other spouse earned all the income.
Spouses may be relieved of responsibility for tax, interest, and penalties on a joint return under certain relief rules, and new changes make it easier for a taxpayer to qualify for these types of relief.
Married Filing Separately
This status is used when married taxpayers do not wish to file jointly. A variety of laws are written into the tax code to prevent married taxpayers who are filing separate returns from taking advantage of any loopholes. Some of the requirements include the following:
– Both taxpayers must either itemize their deductions or take the standard deduction.
– The taxable income threshold for Social Security for married separate taxpayers is zero (as opposed to $32,000) to prevent taxpayers from splitting their income and reducing it below the threshold.
– Passive income losses limits are cut in half from the limit for married taxpayers and the phase-out occurs between $50,000 and $100,000.
Spousal Buy-Out Debt
Your home mortgage interest is limited to the interest on acquisition debt and $100,000 of equity debt. However, through divorce proceedings, one spouse will sometimes buy out the other, and the buying spouse often incurs additional debt to do so. The IRS has stated that in this situation, the additional debt, secured by the home, to buy out other spouse will be treated as acquisition debt.