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The Tax Aspects of Divorce or Separation
It is strongly recommended that before any settlement agreement is finalized, that the parties consult with a tax attorney or tax accountant to review the tax consequences of the agreement.
This article is not meant to be a complete analysis of the Internal Revenue Code, but a general outline of some of the tax ramifications of divorce and separation.
One of the most important aspects of negotiating a settlement in conjunction with a divorce is taxes and how they affect the parties. Parties can chart their own course concerning taxes so long as it does not contravene the tax laws.
Child support is a payment by the non-custodial parent to the custodial parent. Child support obligations are governed by state law. The payments made for child support are non-deductible by the payor and are not includible as income by the payee.
Effective January 1, 1985 the custodial parent has the right to claim the dependency exemption for the child/ren, unless he/she waives that right. The custodial parent may waive that right by executing IRS Form 8332. The form must be attached to the non-custodial parent's tax return. TAX TRAP Failure to provide in an agreement, for the allocation of the dependency exemption/s, automatically gives the custodial parent the right to claim the exemption/s.
Alimony is a payment by one spouse to the other pursuant to a divorce decree, separation decree, or a written agreement including a separation agreement. Alimony is deductible by the payor and includible as income to the payee, provided it meets certain requirements set forth in the Internal Revenue Code(see IRS Publication 523). Parties may elect to treat alimony payments as non-deductible by the payor and not taxable as income to the payee. When alimony payments exceed $15,000.00 per year there are strict requirements to be met in order to insure the deductibility of those alimony payments.
Payments to a third party on behalf of a spouse may be alimony (tax deductible). For example, a life insurance policy owned by the husband and designating the wife as beneficiary can be assigned to the wife who then becomes the owner of the policy. Payment of the premiums by the husband constitute alimony payments. The wife must be the owner of the policy at the time the premium is paid.
Transfer of Property
There is no gain or loss recognized when one spouse transfers property to the other spouse. The same rule applies to transfers to former spouses if the transfer is incident to a divorce (IRC 1041).
Sale of Marital Residence
When a capital asset, such as the marital residence, is sold, there may be a capital gain. A capital gain is generally determined by subtracting the cost basis (plus capital improvements) from the net sales price. For sales occurring after May 6, 1997 individuals are permitted to exclude from income up to $250,000.00 of the gain from the sale of their principal residence. Married couples, filing a joint tax return, are permitted to exclude up to $500,000.00. In order to qualify, the taxpayer must have owned and used the residence as a principal residence for at least two years prior to the sale. There is no longer an age requirement and the exclusion can be used as many times as the taxpayer qualifies. The "rollover" provision of the Internal Revenue Code (IRC 1034) has been repealed. A spouse is considered to have used the marital residence as a principal residence during any period when: the spouse owned the property; and the other spouse is permitted to use the marital residence pursuant to a divorce agreement or a separation agreement. This provision eliminates a major tax trap for divorced or separated persons who reside outside of their principal residence after a divorce or separation. TAX TRAP If a spouse resides outside of the home, voluntarily, i.e. not pursuant to a divorce agreement or a separation agreement for more than two years and the home is then sold, the excluded spouse is not eligible for the exclusion since it was not his/her principal residence for two years prior to the sale. The maximum tax rate on the net capital gains has been reduced from 28% to 20%.
Legal fees for obtaining a divorce are not deductible. A person may be able to deduct legal fees for tax advice incident to a divorce or separation. TAX TIP Ask your attorney to allocate his/her bill indicating what part of the fee was for tax advice. In addition, legal fees incurred for obtaining alimony that is includible in income may be deductible.
Married persons may file joint tax returns provided they are married on the last day of a calendar year. If a married couple file separate tax returns, they can change to a joint return within three years from the due date. Parties that are separated by an agreement are permitted to file joint tax returns. If the parties are divorced on the last day of the calendar year or are separated by a judicial decree of separation they cannot file joint tax returns. TAX TIP If the parties will benefit by the filing of a joint tax return and it appears that a divorce will be entered before the end of the calendar year, it is possible to delay the filing of the divorce until the beginning of the following year.
The Internal Revenue Service is a good source for information for the tax aspects of a divorce or separation. You can call the Internal Revenue Service at 800/829-3676 and request Publication 504 entitled Tax Information for Divorced or Separated Individuals and Publication 523 entitled Tax Information on Selling Your Home. These publications are free.
Marital property is all property earned or acquired during the marriage. Separate property is that owned by one party before the marriage. In New York, separate property is awarded to that individual. However, the increase in value of separate property that occurs during the marital period may be divided under the equitable distribution system. Separate property also includes gifts or inheritances received during the marriage.
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