Divorce and Taxes: What You Need to Know for Filing

Divorce affects almost every aspect of your tax situation, from your filing status to your deductions to the tax treatment of support payments. Failing to account for tax implications can turn a seemingly fair settlement into a financial disadvantage. This guide covers the key tax issues you need to understand during and after divorce.

Filing Status During and After Divorce

Your filing status for the tax year depends on your marital status on December 31 of that year:

• If your divorce is finalized by December 31: You file as single or head of household
• If your divorce is not finalized by December 31: You may file as married filing jointly or married filing separately
• Head of household: If you are unmarried at year end, paid more than half the cost of maintaining a home, and your child lived with you for more than half the year, you may qualify for this advantageous status

Married Filing Jointly vs. Separately During Divorce

Filing jointly usually results in a lower total tax bill, but it also creates joint liability. If you are concerned about your spouse's financial honesty, filing separately protects you from liability for any errors or fraud on their return. Consider the tradeoffs carefully and consult a tax professional.

Alimony and Tax Treatment

The tax treatment of alimony depends on when your divorce was finalized:

• Divorces finalized before January 1, 2019: Alimony is deductible by the payer and taxable income for the recipient
• Divorces finalized on or after January 1, 2019: Alimony is not deductible by the payer and is not taxable income for the recipient

This change significantly affects the economics of alimony negotiations. For post-2018 divorces, a $3,000 monthly alimony payment costs the payer $3,000 and the recipient receives $3,000. There is no tax benefit or burden for either party.

Child Support and Taxes

Child support is never deductible by the payer and never taxable income for the recipient, regardless of when the divorce occurred.

Who Claims the Children?

The parent who has primary physical custody, meaning the child lives with them for more than half the year, generally claims the child as a dependent. However, the custodial parent can release this claim by signing IRS Form 8332, which allows the noncustodial parent to claim the child. This can be a useful negotiation tool. Related tax benefits include:

• Child tax credit: up to $2,000 per qualifying child
• Earned income tax credit for qualifying taxpayers
• Child and dependent care credit
• Education credits for older children

Property Transfers Between Spouses

Transfers of property between spouses as part of a divorce settlement are generally tax-free at the time of transfer. However, the receiving spouse takes on the transferring spouse's tax basis. This means the tax bill is deferred, not eliminated.

For example, if you receive stock that was purchased for $10,000 but is now worth $50,000, you will owe capital gains tax on $40,000 when you eventually sell it. This makes it essential to consider the after-tax value of assets during settlement negotiations, not just the current market value.

Retirement Account Transfers

Transfers of retirement accounts pursuant to a divorce are tax-free when done correctly through a QDRO for employer plans or a transfer incident to divorce for IRAs. Incorrect transfers can trigger taxes and early withdrawal penalties.

The Family Home

If you sell the family home, each spouse can exclude up to $250,000 in capital gains if they meet the ownership and use tests. If one spouse keeps the home and sells it later, they may only qualify for the $250,000 single exclusion rather than the $500,000 married exclusion.

Tax Implications of Selling Assets

When dividing assets, consider the tax cost of each asset:

• Cash has no embedded tax liability
• Stocks and investments have potential capital gains taxes
• Retirement accounts have deferred income taxes
• Real estate may have capital gains taxes above the exclusion amount
• Business interests may trigger capital gains upon sale or transfer

Innocent Spouse Relief

If your spouse improperly reported items or omitted income on a joint return filed during your marriage, you may qualify for innocent spouse relief. This can relieve you from paying additional tax, interest, and penalties attributable to your spouse's errors.

Post-Divorce Tax Checklist

1. Update your W-4 with your employer to reflect your new filing status
2. Adjust your estimated tax payments if you are self-employed
3. Update beneficiary designations on all accounts
4. Review your withholding to avoid a surprise tax bill
5. Keep copies of your divorce decree and settlement agreement for your tax records
6. Consult a tax professional for your first post-divorce tax return