One of the first issues to tackle when preparing your taxes is deciding which filing status to use. If, like many people, you qualify to use more than one filing status, you should use the one that is most advantageous for your situation. But what happens when divorce enters the picture?
Ringing in the new year
Your marital status will determine your filing status options. Simply put, your marital status for tax purposes is whatever it was under state law when the clock struck midnight on New Year’s Eve. If you got married at 11 p.m. on New Year’s Eve so you could ring in the new year with your brand-new spouse, you are considered married when you file your tax return for the year. Similarly, if your divorce was not finalized until January 3 of the following year, then you are still married for tax purposes when you file your return for the previous year. (I have actually assisted people in both of these situations.) For parents who are separated, but not yet divorced, it can be more complicated. These realities should be considered when structuring a prenuptial agreement or divorce settlement.
As the title suggests, this article will focus on divorce-related tax issues. If your soon-to-be ex is agreeable, you may even want to time your filing because it could make a significant difference tax-wise.
Children
If you have children, that will likely be the biggest sticking point – and the largest source of misunderstanding – when negotiating and implementing a divorce settlement. (If you are childfree, you can skip this section entirely.) This discussion also applies to parents that were never married under state law to one another.
There are five main potential tax benefits related to children: head of household filing status, earned income credit, credit for child and dependent care expenses (sometimes called the child-care credit), dependency deduction/exemption, child tax credit (including the additional child tax credit) or credit for other dependents, and education credits. Before determining how these are handled, though, you must determine which parent is the custodial parent.
Who is the custodial parent?
Assuming it has jurisdiction to make custody orders, the court will determine both legal custody and physical custody of a child. Legal custody refers to the authority to make major decisions regarding upbringing, like religion, schooling, etc. Physical custody refers to actually taking care of the child.
For tax purposes, there can only be one custodial parent, and this can change from year-to-year. Regardless of what the court says, the custodial parent for tax purposes is the parent with whom the child spends the most overnights during the year. Yes, this may mean getting out calendars and actually counting. There are tiebreakers if it comes out equally. (I have assisted people with this as well!) Even if the court says you have primary physical custody, if your child actually spends more time with your ex, then your ex is the custodial parent for tax purposes. The IRS will not get into a marital dispute; if the realities are the result of shenanigans, file your taxes properly and then head to court to seek redress. (This is where it helps to know a tax expert who has also represented clients in divorce cases as an attorney. Contact me for help!)
Which benefits can be traded, and which cannot?
Besides making custody orders, a court decree often simply allocates the “tax deduction” related to a child to one of the parents in some fashion (for example, odd-numbered tax years). This can cause strife when filing taxes because some child-related tax benefits can be allocated as the parents (or a court) see fit, but others cannot.
Only the custodial parent (see above) can claim a child for purposes of the head of household filing status, earned income credit, and credit for child and dependent care expenses. Full stop. If you are not the custodial parent, under federal law you cannot use the child as a qualifying person for any of these tax benefits.
On the other hand, the parents can decide which one of them claims the child as a “dependent” in any manner they see fit. (The deduction/exemption for dependents is currently zero for federal tax purposes, but it may still be relevant for your state return.) Only the parent claiming the child as a dependent can claim the child tax credit (including the additional child tax credit) or credit for other dependents – whichever is available based on the age of the child – plus any education credits if applicable.
The default rule is that the custodial parent (again, see above) gets to claim the child as a “dependent.” If you are the custodial parent, you get to claim these benefits unless you allow the noncustodial parent to claim them. Be sure to follow any court orders! (You can even include a clause in your divorce settlement providing a “buy-out” option each year, but do not attempt this without professional help.) To allow the noncustodial parent to claim a child as a dependent, complete Form 8332 and give it to the noncustodial parent. You can do this each year (my recommendation), or you can fill the form out once and indicate that it applies to future years as well.
If you are the noncustodial parent, you must have a completed Form 8332 from the custodial parent to claim the child as a “dependent.” (But remember, even then you still cannot use the child for purposes of the head of household filing status, earned income credit, and credit for child and dependent care expenses.) If you do not have that form, no dice – even if a court order says you get these benefits, the IRS cannot help you. (I can help if your co-parent claims tax benefits that the court awarded to you.)
Property Division
Besides children, the other major topic to consider in a divorce is property division. This means you must divide up all your assets, including retirement accounts, and all your debts.
The good news here is the general rule that property transfers incident to divorce are nontaxable events (including gift tax limitations). Basis in any assets transferred will generally carry over as well.
A divorce is one of the few times when you can transfer all or a portion of a retirement account or health savings account to another person. For example, if you split your 401(k) with your ex-spouse pursuant to a divorce decree, your ex-spouse will typically need to report it on their taxes, but as a nontaxable direct rollover.
Child Support and Alimony
Two other ancillary topics to child custody and property division are, unsurprisingly, child support and alimony (sometimes called “spousal support” or “spousal maintenance”).
Child support is easy because it is nontaxable. It is not a deduction for the person paying child support, and it is not income to the person receiving child support.
Alimony is a little trickier for two reasons. First, you must determine that a payment really is alimony. Just because you and your ex agree that a payment is alimony, that is not enough. The rules here can be a little complicated. Second, assuming a payment is indeed alimony, whether it is taxable – i.e., a deduction for the person paying alimony and income for the person receiving alimony – depends on the date of the divorce or separation agreement.
Alimony payments made pursuant to a divorce decree finalized in 2018 and earlier are taxable events, while alimony payments under a decree finalized in 2019 and later are nontaxable. Earlier agreements can also be modified to change alimony from taxable to nontaxable. For example, if your 2016 divorce decree required your ex-spouse to pay alimony, your receipt of that alimony was taxable then, is taxable now, and will continue to be taxable in the future unless you modify the decree to make alimony nontaxable.
Depending on how the math works out, an alimony modification could be beneficial to both parties! Reach out to me for a consultation if you are paying or receiving taxable alimony.
Name Change
Finally, divorce decrees should specify whether either or both spouses are changing their names. This does not affect the numbers on your tax return, but be sure to update your name with the Social Security Administration before filing your taxes (or wait until after you file your taxes and receive your refund, or pay the balance due, before updating the SSA). The IRS will reject the return if there is a name-number mismatch. (Then be sure to remember to update your passport, driver license, voter registration, etc.; if you are traveling, make sure the name on any reservations matches the name on your ID.)
As you can see, there are tax implications to consider when structuring or implementing a divorce settlement. Be sure to keep them in mind to avoid unintended results!
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