Summary in Divorce
The pain of divorce can be made worse by its tax consequences, particularly when they are unforeseen.
In general in a divorce, two tax considerations are 1) tax consequences, which include incomes and deductions of the spouses, number of dependents, credits, tax rates and the amount tax paid to avoid penalties, and 2) legal liabilities, particularly those associated with a married filing jointly, which include joint and several liability. A prudent divorce attorney also advises his or her client on any likely tax consequence that may result from the distribution of property. One of the most important tax decisions a divorcing couple make is filing joint or separate returns. A couple who are married on the last day of the year may file jointly even if they are permanently separated in anticipation of a divorce. Couples who file jointly, however, have joint and several liability, which means "both spouses are each entirely responsible for the return and the tax liability and its tax obligations." In general, the I.R.S. ignores any agreements between the spouses about responsibility for taxes; if a deficiency is found, the I.R.S. can pursue either or both spouses for the back taxes and any penalties. Women are often at a disadvantage here because in many marriages men manage the money and wives often sign what their husbands tell them to. Many tax decisions a couple can best determine for themselves if they can act in good faith to one another, including the payment of any balance due on a joint income tax return and the distribution of any refund. Couples with minor children must also decide which spouse takes the dependency exemption, the child care credit, and medical deductions for a dependent child. As long as the divorcing spouses negotiate and honor their agreements in good faith, they can save themselves money and aggravation. In property settlements, transfers between spouses are gifts and are not taxable. However, in order to pay a settlement, sometimes couples must disturb assets in a way that creates tax consequences. For example, taxes may result when a party must withdraw funds from a restricted account, such as a pension fund. Other situations where taxes must be considered is the sale of assets received in a settlement, such as a house, which may create a capital gains liability; when both parties make an in-kind distribution of property, such as set-off and trades; when the parties take future income from a pension to be received later. While the sale of a primary residence can be sheltered from capital gains of up to $500,000, the sale of other real estate may result in taxable events. Generally, spousal support -- alimony -- is treated by the I.R.S. as income shifting. It is deductible to the payor and taxable to the payee. As part of their separation agreement, spouses may decide to make the payments nondeductible to the payor and tax free to the recipient. The distribution of any ERISA-qualifed pension, profit-sharing or bonus plan may have adverse tax consequences because under the I.R.S. Code and ERISA these benefits are not assignable, and can only be transferred via a QDRO. Child support is not deductible to the person who pays it, nor is it taxable to the person who receives it. Divorcing spouses must remember what are called I.R.S. recapture rules. Recapture applies to alimony payments when the alimony paid decreases by more than $15,000 annually within a three-year period after a divorce. If in a three-year period a taxpayerís alimony decreases by more than $15,000 from the amount of the proceeding year, the I.R.S. regards the alimony payments as property distribution and recaptures the obligorís income retroactively. In this, the I.R.S. recovers the tax benefit of a deduction or a credit taken by a taxpayer and disallows the deduction. Recapture prevents a divorcing couple from dividing their property and calling the distribution alimony.
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