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Miscellaneous Tax Aspects of Divorce

The Taxpayer Relief Act of 1997 has provided significant changes to the income tax map for individuals and businesses. Some changes which affect the arena of separation and divorce are as follows:

  • The sale of a home is easier due to a new exclusion for capital gains.
  • The dependency exemption is more valuable because three new credits and a deduction are tied to it.
  • The lower capital gains income tax makes property with a low basis more valuable.
  • New IRA rules can make it easier to utilize IRA funds for alimony and equitable distribution.
  • The foregoing changes are incorporated in the following materials.

Miscellaneous Matters.
  • Dependency Exemption.

    • Under Section 152(e) as amended by the Act, the parent having custody of a child for a greater portion of the year is generally treated as having provided more than one-half of the child's support and, therefore, is entitled to the dependency exemption.

    • This general rule applies only if both parents in the aggregate have custody of the child for more than one-half of the year and they furnish more than one-half of the child's support.

    • In addition to applying to divorced or separated parents, the amended rule applies to parents who "live apart at all times during the last six months of the calendar year." IRC 152(e)(1)(A)(iii).

    • Section 152(e), as amended, is subject to three exceptions:

      • The custodial parent may release his or her claim to the exemption to the noncustodial parent. IRS Form 8332.
      • The general rule is subject to the provisions and terms of the separation or divorce agreement.
      • Section 152(e)(4) provides that prior law will continue to apply to separation or divorce agreements that were executed prior to January 1, 1985, and which allocate the dependency exemption to the noncustodial parent.

    • To accomplish a release of this exemption, the custodial parent is required to sign a written declaration that he or she will not claim the child as a dependent for the year. Further, the noncustodial parent must attach the custodial parent's declaration to the return filed by the noncustodial parent for the year. See IRC 152(e)(2) and Temp. Reg. 1.152-4T(a), Q-3.

    • The form and content of the written declaration is set forth in IRS Form 8332 "Release of Claim to Exemption for Child of Divorced or Separated Parents."

    • The Revenue Reconciliation Act of 1990, P.L. 101-508, signed November 5, 1990 (hereafter "1990 R.R.A.") modified the tax brackets and altered the treatment of exemptions. The goal is to phase out the value of an exemption for persons with higher-adjusted gross income.

    • The 1990 Amendments provided a mechanism by which 2% of the value of the exemption is lost for each $2,500.00 ($1,250.00 for married filing separately) or fraction thereof, where the taxpayer's adjusted gross income exceeds certain threshold amounts. These specified amounts are as follows:

      • $150,000.00 on a joint return or surviving spouse;
      • $125,000.00 for head of household;
      • $100,000.00 for single taxpayers; and
      • $75,000.00 for married person filing separately.

    • The threshold amounts have been adjusted upward each year, so reference to the Master Tax Guide or other reference material is advisable.

  • The New Tax Credits.

    • The Taxpayer Relief Act of 1997 changes give parents an annual credit for each child under age 17, which is $400.00 in 1998 and $500.00 thereafter. In addition, there are two new credits for education expenses, which can amount to several thousand dollars or more for each child going to college or graduate school. A divorced parent can use these credits only if he or she has the dependent exemption for the child(ren) to whom it applies. Some consider the net value of the dependent exemption so minimal as to not be worth the time and money to negotiate or "fight" to receive it.

    • The credits also affect the issue of who should get the dependency exemption for purposes of minimizing the couple's total tax. Divorcing couples frequently agree to allocate the exemption to the spouse with the higher tax bracket, because he or she will get greater tax savings from it than the other spouse. Typically, the exemption is transferred from the custodial spouse, who is entitled to it, to the other spouse. Of course, this does not make sense if the other spouse's income is so high that the exemption would be "phased out." The new credits complicate things because they "phase out" at lower income levels than the exemption does.
    • Example: For someone filing a single return, the exemption for 1997 begins to phase out at adjusted gross income of $121,200.00 but the $500.00 credit begins to phase out at $75,000.00 and the two education expense credits begin to phase out at $40,000.00 (adjusted for inflation). Therefore, the couple's total tax may be lower if the exemption stays with the lower-bracket parent.

      Example: A husband has income of $120,000.00. The exemption equals $2,650.00 and he is in the 31% tax bracket, so it would lower his taxes by $821.00. The wife has income of $40,000.00. She is in the 28% tax bracket, so the exemption would lower her taxes by $742.00. By itself, the exemption would be worth $79.00 more if the husband takes it and if the wife does not. However, the wife can fully use the credits, while the husband cannot use them at all. So if the value of the credits exceeds $79.00, the total taxes are lower if the exemption is allocated to the wife.

    • The $500.00-per-Child Credit. IRC 24

      • The $500.00-per-child credit can be taken for a dependent who is a direct descendent, stepchild or foster child. The credit begins to "phase out" at adjusted gross income of $110,000.00 for joint filers, $75,000.00 for single filers and heads of household, and $55,000.00 if married filing separately. Above these levels, the total credit for all children is reduced by $50.00 for each $1,000.00 of income (or part thereof). Neither the amount of the credit nor the phase-out numbers will be adjusted for inflation.

    • The "Hope Scholarship Credit". IRC 24A

      • The Hope Scholarship Credit is for up to $1,500.00 per child per year of tuition and related expenses during the first two years of post- secondary education. Each of the first two years it will equal 100% of the first $1,000.00 of tuition and fees, and 50% of the next $1,000.00. The credit phases out at adjusted gross income levels between $80,000.00 and $100,000.00 for joint filers and between $40,000.00 and $50,000.00 for others. Both the amounts of the credit and the phase-out numbers will be adjusted for inflation starting in 2001. The credit generally applies to expenses paid after 1997 for an academic period starting after 1997.

    • The "Lifetime Learning Credit". IRC 24A

      • The Lifetime Learning Credit is for tuition and related expenses and can be used for undergraduate-level education or for job-training courses. Until 2002, the credit is equal to 20% of up to $5,000.00 of expenses. Beginning in 2002, it is equal to 20% of up to $10,000.00. Unlike the Hope Scholarship Credit, this credit is not per child, but is what a taxpayer can take each year for all children combined. The credit can be used for expenses paid after June 30, 1998, for education beginning after that date. The phase-out schedule for this credit is the same for the Hope Scholarship Credit.
      • It should be noted that neither education credit can be used for a child in which any of the child's education expenses are paid with tax-free distributions from an "Education IRA" - a type of IRA created by the new tax law.

  • Interest on Education Loans. IRC 221

    • The new law also makes the dependency exemption more valuable by allowing taxpayers to deduct interest on loans taken out to pay a child's education expenses. To be able to take the deductions, the taxpayer must claim the child as a dependent in the year the loan was taken. The deductions must be for interest that is due and paid after 1997. The maximum deduction will be $1,000.00 in 1998, $1,500.00 in 1999, $2,000.00 in 2000 and $2,500.00 thereafter. Interest can be deducted that is paid during the first 60 months in which interest payments are required on the loan. The deductions phase out at adjusted gross income levels between $60,000.00 and $75,000.00 for those filing jointly, and between $40,000.00 and $55,000.00 for others. (These numbers will be adjusted for inflation after 2002).

  • Head of Household Filing Status.

    • The Internal Revenue Code grants special relief to unmarried, divorced taxpayers. A divorced taxpayer may choose between single or head of household filing status. To qualify for head of household status, a taxpayer must meet the following:

      • Not be married at the close of the tax year;
      • Not be a surviving spouse;
      • Maintain a household that constitutes the "principal place of abode" for a child for more than one-half of the tax year; and
      • Furnish over one-half of the cost of maintaining the household during the tax year.

    • Although only one of the divorced spouses may qualify for head of household status, both parties may secure tax benefits from raising the child. A taxpayer does not need to claim the child as a dependent in order to qualify as head of household. Therefore, a spouse who qualifies for head of household status may transfer to the former spouse the right to take a dependency exemption pursuant to Form 8332.

    • A married taxpayer will be considered unmarried and eligible for head of household status if the taxpayer spouse was not a member of the household for the last six months of the year and if the household is the principal place of abode of a child for whom the taxpayer is entitled to a dependency exemption.

  • Child and Dependent Care Credit. IRC 21

    • Generally, the taxpayer with a child under age 13, or a person is physically or mentally unable to care for himself, is eligible to claim the child and dependent care credit as long as that taxpayer is eligible to claim the dependency exemption for that child or person on his or her tax return. The child or dependent care expenses must be paid to allow the taxpayer to be gainfully employed.

    • When parents are divorced or separated and filed separately, only the custodial parent can claim the child care credit even if both parents have paid child care costs.

    • Eligibility for the dependency exemption generally determines whether the parent can claim the child care credit.

    • When the custodial parent is eligible to claim the dependency exemption but does not because he or she transferred the right by agreement or because of pre-1985 agreement is in effect, the custodial parent is still entitled to the child care credit.

    • If the eligible parent does not spend an amount sufficient to qualify for the maximum credit, he or she cannot use amounts spent by the ineligible parent to increase the amount of the credit. Only the expenses paid by the eligible parent qualify for the credit. The ineligible parent cannot use the unused credit even if he or she also paid for child care.

    • The noncustodial parent cannot claim the credit because even in the case of divorced or separated parents the household must actually be the principal place of abode of the taxpayer/claimer and child.

    • The Child and Dependent Care Credit is computed on IRS Form 2441 or Schedule 2 of IRS Form 1040A, whichever is applicable.

    • The maximum amount of employment-related expenses to which the credit may be applied is $2,400.00 if one qualifying child or dependent is involved or $4,800.00 if two or more children are involved, less excludable Employer Dependent Care Assistance Program payments. The credit is equal to 30% of employment-related expenses for taxpayers with adjusted gross incomes of $10,000.00 or less. The credit is reduced by one percentage point for each $2,000.00 of adjusted gross income (or fraction thereof), over $10,000.00, until it decreases to 20% for taxpayers with adjusted gross incomes of over $28,000.00.

  • Medical Expenses. IRC 213(a)

    • Generally, payment of a child's medical expenses or insurance premiums are not deductible.

    • If the child is the dependent of the payor, however, then the payor would be entitled to deduct, under Section 213(a), the child's medical expenses along with his own.

    • The Tax Reform Act of 1984 modified IRC 213 to provide that, for purposes of the medical expense deduction, a child is treated as a dependent of both parents. Consequently, a parent can deduct medical expenses that he or she paid for the child even if he or she is not entitled to a dependency exemption for the child. See IRC 213(d)(5).

    • The deduction is only allowed if the medical expenses exceed 7.5% of adjusted gross income as opposed to the previous requirement that the medical expenses were deductible if they exceeded 5% of adjusted gross income. Also, for tax years beginning after December 31, 1990, the amount of the deduction must be reduced by the amount (if any) of the health insurance credit. See IRC 32(a)(2) and IRC 213(a).

  • Capital Gains Tax Under the Taxpayer Relief Act of 1997.

    • The Taxpayer Relief Act of 1997 lowers the income tax rates for capital gains. It makes a number of complicated changes to both the rates and the "holding periods." Most importantly, the maximum rate on property held for more than 18 months is lowered from 28% to 20%.

    • Any net taxable gain which would otherwise be taxed at 15% is taxed at 10%.

    • However, for transactions taking place on or after May 7, 1997, and before July 29, 1997, a special transition rule allows investors to take advantage of the 20% (or 10%) rate by simply having met the old "more-than-one- year" holding period.

    • In addition, for taxable years beginning after December 31, 2000, the maximum capital gains rates for assets held more than five years are 18% and 8% (rather than 20% and 10%). Note that the 18% rate only applies for assets whose holding period begins after December 31, 2000 (for example, a stock purchased in the year 2001). And, under a special rule, taxpayers may elect to treat an asset held on January 1, 2001, as having been sold on such date at fair market value and then reacquired for the same amount. If the election is made, any gain is recognized and any loss is disallowed. Then, the asset may qualify for the lower 18% rate, if all other requirements are met.

    • The new law does contain certain exceptions, such as investments in collectibles (stamps, coins and artwork, for example). Net capital gain attributable to collectibles will continue to be taxed at a maximum rate of 28%.

    • Owners of certain depreciable real property (residential rental property, for example) should take note of another exception. Net capital gain attributable to such property will not qualify for the lower rates in its entirety. Instead, to the extent depreciation has been claimed on the property (technically, "allowable" depreciation, whether or not claimed), the gain will be taxed at a maximum rate of 25%.
    • Example: Mr. and Mrs. Z own a rental property which they bought several years ago for $100,000.00. So far, they have taken $15,000.00 in depreciation deductions, so that the property's adjusted tax basis in their hands is now $85,000.00. They sell the property in 1998 for $150,000.00, realizing a $65,000.00 long-term capital gain. Assuming the couple is in the 39.6% tax bracket, $15,000.00 of their gain - the amount of the depreciation they claimed - will be taxed at 25%. The rest of the gain, $50,000.00 will be subject to tax at 20%.

  • IRA Withdrawals.

    • In the past, there was a 15% "excise tax" when someone made an excess withdrawal from an IRA. This has been repealed for withdrawals after December 31, 1996. The excise tax generally was applied with very large IRAs. During 1996 there had already been a moratorium as to the tax on large withdrawals.

    • Early withdrawals from an IRA causes a 10% penalty should the withdrawal be before age 59 1/2. While the Code does permit pre-age-59 1/2 withdrawals without penalty in some circumstances (disability, for example), these situations are limited. The new law expands the number. In addition to education- related withdrawals, the new law allows distributions for qualifying first-time homebuying expenses up to $10,000.00 without penalty, effective for 1998 and later years.

The author gratefully acknowledges the authors who have developed extensive materials on the foregoing subjects for the Pennsylvania Bar Institute, published same and lectured extensively throughout Pennsylvania in the series entitled: Tax Traps in Divorce Law, PBI 1995-961. The authors upon whom the undersigned relied included the undersigned, Stewart B. Barmen, Daniel H. Glasser, Denise W. Ford (Buchanan Ingersoll, P.C. - Pittsburgh), Maria P. Cognetti (Harrisburg), Dennis L. Cohen (Philadelphia) and David N. Hofstein (Philadelphia). The extensive input from the author's materials and their materials included in the within text is acknowledged and appreciated.

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