Divorce Tax Considerations

Transcription

1 Divorce Tax Considerations Divorce is a tough process, and one that doesn t end after a court date. Knowing your rights and obligations and understanding tax implications will make the process less difficult. 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. 1

2 Getting a copy of Tax Return Information for previous years can help uncover hidden assets, give you proof of your spouse s income, and reveals retirement accounts. o Getting a copy of tax return data for at least the three previous tax years is important when going through divorce, especially if you signed the returns without looking at them. o This will help your lawyer uncover hidden assets, reveal retirement accounts, and give your proof of your spouse's income, and can also help you in the event of an IRS audit. o You have a legal right to a copy of any joint income tax returns that were signed by both you and your spouse. o You can get a copy of your returns from the IRS, sometimes from the state, from a paid preparer, or from your spouse who filed the taxes. The IRS provides tax return transcripts for 1040, 1040A, and 1040EZ returns. Request for transcripts can be made by calling

3 Filing a Joint Tax Return Before The Divorce is Finalized o Your tax filing status depends on your marital status on the last day of the tax year. If you are unmarried, your filing status is single or head of household. If you are married, your filing status is either married filing a joint return or married filing a separate return. o You must also follow your state law to determine whether you are considered divorced or legally separated. o Even if you live separately, as long as you were still married you have the option to file married filing jointly. o More often than not there is a monetary advantage to the filing status married filing jointly. But remember that you can only file a joint return if you are married. o If you decide to file "Married Filed Separately," you cannot claim Earned Income Tax Credit. So, if you have children and your income qualifies you for Earned Income Tax Credit, you may consider working together to file jointly and share the amount of the Earned Income Tax Credit. 3

4 Capital Gains Tax in Divorce Settlements o Addressing the capital gains tax in divorce settlements is something that is often overlooked when couples split up. If you will be keeping the marital home, you need to consider how the eventual sale of the home will affect your taxes when drafting your divorce agreement. o In order to qualify for an exclusion, your home must be your primary residence and you must have owned and occupied your primary residence for at least two of the last five years prior to the sale. o To figure the gain on the sale of your home you will need to know your basis. For most people, it is the original amount you paid for your home. However, if you have made any improvements or taken any deductions then you will need to calculate your adjusted basis. For example, if the original cost of your home was $200,000 and you added a $10,000 pool, your adjusted basis becomes $210,000. If you then took an $8,000 loss for a flood, your adjusted basis becomes $202,000. o To calculate your profit or loss, you should subtract the adjusted basis from the selling price of the home. If the number is positive, you have a gain. If the number is negative you have incurred a loss. Your taxable gain Please call Legal Aid of Arkansas with your divorce and taxation questions. Our helpline is available at for free help. 4 17

5 be some tax advantages to using alimony, even if a judge wouldn't ordinarily award it. A spouse with a significantly larger income could pay a substantial alimony instead of child support. Many times, the spouse with the large income can afford to pay enough alimony to compensate the recipient spouse for the extra tax they will have to pay and still save money. o In order for payments to an ex spouse to constitute alimony, there are several requirements that you have to satisfy. They are outlined in IRC 71. The payments must be in cash, checks, or money orders. Alimony cannot be made in debt, property, or services. The payments must be provided for in a divorce or a written agreement. You can't claim alimony during any year for which you file a joint tax return. You can't claim alimony while sharing a residence with your spouse. The payments have to stop when the recipient divorcee dies. o If both parties to the divorce have similar incomes, it is probably best to use child support instead of alimony. The noncustodial spouse making the payments is likely unable to compensate the custodial parent for the extra taxable income they must claim on their taxes. is determined by subtracting the maximum allowable exclusion from any profits. o If you find that you have a taxable gain, you should consider inserting a clause in your divorce agreement that states: The parties agree that the real estate, located at X Street, Xville, Arkansas, zip code, shall be listed for sale at market price. Net proceeds of this sale after deduction of all expenses, taxes, liens and mortgages will be divided as follows X% to the Wife and X% to the Husband. Child Tax Credits After Divorce Find out if you qualify for a child tax credit, 16 5

6 child care credit, earned income credits, or any education tax credit. o In general, there are four different types of child tax credits that divorcing parents should understand before resolving which parent will claim the dependency exemption and/or how joint custody should be addressed in an agreement. o Child Tax Credits (For Parent Claiming Dependent) Taxpayers may be able to claim a child tax credit of $1,000 for each qualifying child. In this case, a qualifying child is one that is claimed as a dependent, was age 16 or younger at the end of the year, and is a child that is the taxpayer's own (or that of their brother or sister and is cared by them as their own child). The child tax credit is phased out if adjusted gross income is above $75,000 for Head of Household and Single filers. Note this credit is refundable. o Child and Dependent Care Credit (Claimed by Custodial Parent) If a custodial parent pays for care for a qualifying dependent that was age 12 or younger when the care was provided or for other dependents that are not able to care for themselves, then they may be eligible for the child household filers. The credits are generally more valuable to low and middle income filers than the dependency exemption itself. **Remember that the custodial parent is the only parent eligible for additional tax benefits, such as filing as Head of Household, the Earned Income Credit, and the Child and Dependent Care Credit** Alimony and Child Support: o Alimony is tax deductible to the person who pays it, and included in the taxable income of the person who receives it. Child support, by contrast, is not considered taxable income to the person who receives it and not tax deductible to the person who pays it. o When two parties to a divorce have dramatically different incomes, there may 6 15

7 The custodial parent, for 2009 and forward, is the one with whom the child resides the greater number of and dependent care credit. To qualify, one must satisfy all of the IRS tests summarized below: nights during the year, regardless of the terms of the divorce decree. You must keep up a home that the dependent lives in paying at least half of The custodial parent can unilaterally the cost associated with owning and revoke the release of a child exemption running the home. You must have earned income for the year, for calendar years 2009 and forward, and the payments for care were required even if the release was made prior to to earn income You must identify the care provider on o Given these changes, all non custodial your taxes and they cannot be someone parents who plan to take a dependency you could claim as a dependent (i.e. not an exemption should obtain Form 8332 for older child) and all future tax years. Your tax filing status cannot be married o For any future settlement agreements that will include a provision for a non custodial parent to take a dependency deduction for one or more children in one or more future tax years, have the custodial parent complete Form 8332 coincident with executing a settlement agreement. o Do not forget that the individual claiming a dependency exemption is entitled to benefit from a Child Tax Credit and any allowable Hope and/or Lifetime Learning Educational Tax Credits. o For 2009, the Child Tax Credit phases out from $75,000 to $95,000 (of Adjusted Gross Income) and Hope and/or Lifetime Learning Educational Tax Credits phase out from $48,000 to $58,000 for single and head of filing jointly or qualifying widow(er) without a dependent. This credit can be up to 35% of up to $3,000 of expenses associated with the care of one individual or up to 35% of $6,000 for two or more individuals. If the taxpayer's adjusted gross income is more than $15,000, they will receive less than the full credit (i.e the "phase out" begins). However, for taxpayers with more than $45,000 of adjusted gross income, the credit is still 20% of qualifying expenses (i.e. up to $600 for one child, $1,200 for two or more). Note this credit is not refundable. o Earned Income Credits (Claimed by Custodial Parent) 14 7

8 The earned income tax credit (or EIC) is a refundable credit that is often the most valuable of all the tax credits. It can only be claimed by the custodial parent. The value can be slightly more than $3,000 if the taxpayer has one child to more than $5,500 for three or more children. To claim the credit, a taxpayer must have earned income of less than $35,000 with one qualifying child and up to $45,000 for three or more qualifying children. There are other qualifying rules, and as was the situation with the Child and Dependent Care Credit, a worksheet is provided on the 1040 tax form to calculate the exact earned income credits. o Education Tax Credits There are two tax credits that presently apply to education the American Opportunity Tax Credit ("AOTC") and the Lifetime Learning Credit ("LLC"). In any year, a parent claiming a dependent can only take one of the credits. The maximum AOTC is $2,500 and is subject to phase out when modified adjusted gross income is over $80,000 (or $160,000 for jointly filed returns). and the other child lives with the other parent more than half of the year. If audited, the parents will need to provide evidence that the dependent child spent more than 182 nights with the appropriate parent. o Note that if one qualifies as Head of Household, they generally qualify to benefit from any related "dependent care credit" and/or "Earned Income Tax Credit" that may be applicable. The party taking the dependency exemption generally qualifies to benefit from the "child tax credit" and any extra stimulus rebates that may be provided in a given tax year. The Dependent Tax Deduction after Divorce. o In 2008, the IRS amended Section 152(e), which deals with dependency exemptions. The changes to the tax code can be summarized as follows: A divorce agreement or court order can no longer be used as a substitute for Form

9 o Most people are under a misconception that claiming a child as a dependent entitles them to file HOH. To qualify, you must satisfy all of the following requirements: You must be unmarried at the end of the year or live apart from your spouse for more than six months; You must maintain a household for your child (even if you do not claim them as a dependent), or a dependent parent, or other qualifying dependent relative; The household must be your home and generally must also be the main home of the qualifying dependent (i.e. they live there more than half the year); You must provide more than half the cost of maintaining the household; and You must be a U.S. citizen or resident alien for the entire tax year. As indicated above, a taxpayer does not need to claim a dependency exemption to file HOH. So, for a custodial parent, even in years when you "give" (by completing IRS Form 8332) the dependency exemption to you ex spouse, you can still file HOH. o The key to ensuring Head of Household tax filing status generally lies in the custody arrangement. If an agreement provides joint custody, it may be helpful to indicate in the agreement which child lives with which parent for more than one half of the year. o If there are two children, both parents can qualify as HOH, so long as one child lives with one parent more than half of the year, 40% of the credit is refundable. Note this credit is due to expire in The LLC is 20% of the first $10,000 paid for qualifying tuition and related expenses each year. The maximum credit is currently $2,000. Expenses for graduate and undergraduate work are eligible. There is no limit on the number of years that this credit can be claimed. The amount of the credit is phased out if modified adjusted gross income is between $50,000 and $60,000 ($100,000 and $120,000 if you file a joint return). Often it is the case that after divorce, one taxpayer can benefit from the above tax credits to a greater extent than the other. So, when negotiating a divorce settlement, learn how the various tax credits would benefit each party. Splitting dependency exemptions is a common practice, but may not take into account how the various tax credits benefit each taxpayer. 12 9

10 Post Divorce Taxes and Claiming the Children Who gets to claim the child exemption, files as head of household, and takes the Health Savings Account tax deductions. o Post divorce taxes are affected by who gets to claim the child exemption, files as head of household, and takes the Health Savings Account tax deductions. o Your divorce decree may specify how this exemption is to be taken. Some parents alternate years. Sometimes one parent always gets it. However, you are permitted to change this if you both agree to do so. You may be in a situation where one parent earns a lot more than the other this year and the exemption will be of more value to that parent (always check with your tax preparer to find out if and how you will benefit from taking the exemption). If you want to shift the exemption to the other parent, there is an IRS Form 8332 that allows you to do so. In amicable divorces, it s not usual to see ex spouses trade off the child dependency exemption. They can do so, and claim related tax breaks each tax year by filing IRS Form o Default Rule: If your divorce decree does not specify which parent gets the exemption, the parent who has the child for the most nights in the year is the parent entitled to take the exemption. Period. It has nothing to do with who pays child support or how much is paid or what kinds of expenses the child has. o MSA and Health Savings Account Tax Deductions. Although the IRS has a hard and fast 50% rule for the dependency exemption, it is possible for both parents to claim children for the purposes of Medical Savings Accounts (MSAs) and Health Savings Accounts (HSAs). If you have one of these employer provided benefits, check with your tax preparer about claiming your child. Head of Household Tax Filing Status o Head of Household Status is separate from the dependency exemption. Even if your ex takes the dependency exemption, you may qualify for head of household if your child lived with you more than half the time, you paid more than half of your household expenses and you are unmarried o Filing as Head of Household ("HOH") can save up to $8,000 per year over filing as Single. Therefore, it is critical to evaluate the post divorce tax filing status for each party when negotiating a settlement. This requires thought and agreement beyond determining who will claim a child as a dependent