Financial Clarity: Tax Implications of Divorce Settlements

A divorce settlement also referred to as a settlement agreement or a financial settlement, marks the final stage of any divorce. It is the final process which revolves around the separation of finances, custody of children if any and the exchange or disposition of assets/debts. As both the individuals decide to move on with their lives without each other, there are a plethora of factors that need consideration before the settlement is finalized. While emotional factors come into play, every person must thoroughly understand all sorts of consequences that adversely or positively affect life after divorce. From psychological changes to financial attributes, it is imperative for the lawyers and their clients to understand how their decisions will impact their future life.

Financial Agreements in Divorces

Financial agreements form a crucial part of divorce settlements all around the globe. A couple must decide how the assets and money need to be split among them to avoid any future issues. Money, property, jewelry, savings, investments, shares, etc. all come under the umbrella of this process. In cases where a prenuptial agreement is already in place, it is responsible for determining how all the assets have to be divided. However, one thing is important. Divorce settlements need to be discussed in detail with the lawyers as once in motion, they are legally binding. If the papers are approved by the assigned judge, there is no going back.

The financial settlement comprises of many elements. For any individual, it is imperative to understand which part is taxable and which is not. Agreements which fail to include tax provisions suffer from adverse consequences. It does not only impact the long-term future of both the parties but can seriously affect the benefits associated with the overall agreement.

Taxes and Divorce Settlements

Not all parts of the financial settlement are taxable. In alimony, the person who receives the amount has to pay the tax and the person who gives the money receives a tax deduction. Furthermore, the settlement regarding alimony takes into account numerous factors as well. Not all money can be considered alimony. Cash exchange must occur and the payment must be done under a proper court order. Moreover, both individuals must live independently once the alimony orders are underway. The tax returns are filed separately by both the parties and no payments are made if the payee or the payer dies. In cases where children are involved, the money offered for child support is not deductible.

Divorce settlements that have property involved are liable to taxes. Therefore, lawyers often suggest couples that one member pays the other one equivalent amount of money. For example, if there is a house, one person can keep it and can give the other member equity which would be considered as a property settlement. In such scenarios, no taxable gains or losses are identified.

Capital Gains Taxes

In order to understand the taxable aspect in a better way, one must understand two important factors which affect the financial settlement: capital gains and income taxes. Capital gains taxes is a term which is used to describe the market value of an asset; the cost of the item is not taken into account. If an individual bought a home for $200,000 for example, and the current value of the house is, let’s say, $300,000, then the capital gain would be equal to $100,000. This equation can be applied to other assets as well whose market value has increased and is more than the price the item was bought. Funds such as investment funds and mutual funds fall under this category. In divorce settlements, capital gains tax is inevitable. Individuals must consider how much capital gain their partner is paying.

A complete analysis of all assets must be done to ensure the capital gains tax is not higher or is at least lower than what the other partner is paying. Usually, people trick their partners into a settlement in which the other has to pay a larger percentage of this tax. To avoid this, the property or any other asset must be thoroughly scrutinized to evaluate the number of capital gains associated with it. In practicing this, individuals will be able to decrease their overall tax liabilities. Consider a scenario in which an individual inherits an asset worth $200,000 but the cost is roughly $75,000. The surplus money would result in capital gains tax which the payee will have to pay for a long time. Therefore, such deals, no matter how lucrative they seem, are not viable. However, the government undertook some reforms regarding taxes applicable to divorce settlements. In 1997, the federal government of the United States of America announced that individuals will be allowed $250,000 exclusion from the capital gain tax per partner if they had lived in a house for two consecutive years in the last five years.

Income Tax

Income tax is another factor which can seriously affect the settlements. All alimony payments are liable to taxes just like any normal income. Usually, a thirty percent tax is cut from the total amount of money the payee receives. Also, the payer faces a tax deduction amount as well. Usually, the percentages are the same. The dependency deduction plays an important role here. Although it is usually resolved by couples by themselves, it can result in a large percentage of tax savings. Dependency deduction is a term that refers to tax exemptions when an individual has custody of one or more children. There are cases where the couple decides to split the children in order to benefit from tax reductions. Also, if the children cannot be evenly split, then couples are advised to evenly divide the children and then the remaining child lives with his/her father and mother from year to year. The same solution is for those couples who have one child. They may wish to alternate. However, in cases where a spouse has the main custody of all the children, no alternatives can be used. In cases where one spouse is receiving the alimony that is taxable, that person might use the dependency claim to reduce the overall taxes.

Deductions Regarding Property

Tax deductions regarding property and mortgage interest is another aspect of a divorce settlement. The main determining factor here is whether the house the couple lived in is a part of the settlement or is being sold. If one person keeps the home, the other one will have to negotiate other parts of the settlements as he/she may not be able to buy a new house after the divorce. If the couple agrees to sell the house, a number of taxes need to be paid. Usually, if one member is living in the house and is paying the mortgage interest and taxes, he/she is more likely to take the amount after the deductions of all the taxes. Spouses living together before the settlement may also divide the total interest and taxes.

Retirement Plans and Taxes

Taxes must also be considered while dividing funds from the retirement plan. Although there is no tax involved during the transferal of funds or assets in a retirement plan, the distribution of funds will require a certain percentage of taxes needed to be paid. A qualified domestic relations orders, also called QDROs, is a process that involves the splitting of a 401(k) plan or any pension account which is similar to it. fundamentally, QDRO refers to a court order that involves the assignment of rights of an employee who has a retirement plan and permits the person to transfer the benefits of to the spouse. The percentage that is transferred is determined by the payer. According to the Publication 575, Pension and Annuity Income, the IRS states that a spouse who gets some percentage of the benefits from a retirement place must report the payments received as if the individual was a plan participant. Moreover, if an interest is transferred to a person from his/her spouse during a divorce settlement, then no tax is applicable to the transfer. Furthermore, there is no tax applicable on the transfer of mutual funds, stocks, bonds or other securities which are outside the retirement plans. Taxes are only applicable is the asset is sold.

Buyouts

There are cases where couples trade their assets. One partner may transfer an asset in exchange for his/her spouse’s assets. People usually take into account the value of the asset being exchanged after the tax is deducted from it. Lawyers usually analyze the after-tax value before exchanging any asset in order to play safe. To divide or exchange the assets, one spouse can pay the other one in cash in exchange for the share bought. In such cases, the equalization payment that is not bound to any taxes and therefore is not deductible.

Spousal buyouts in a divorce are quite common. It refers to the process when one spouse may buy out the share of the other spouse, in business, home or any other asset, during a financial settlement. However, usually, the spouse does not have enough money at once to hand out the cash immediately. In such cases, a mutual installment agreement is signed in which the buyer vows to pay the total amount to the spouse in a certain duration of time after the divorce is finalized. In such agreements, it is imperative to determine beforehand that the agreement is due to the divorce settlement. If this condition is specified, the transfer is not liable to any taxes according to the IRS section 1041. However, one rule regarding this is that the payment must be fully paid within a span of six years after the divorce is settled.

Filing Status

For every couple who plans on drawing a settlement agreement, it is important for them to consider the filing status. If the couple was still married till 12/31 of the tax year, they have the opportunity of filing a joint return with their ex-partner. By doing so, both individuals can save a lot of money from going into taxes. On the other hand, if the couple was divorced after 12/31, tax money can also be saved by filing as head of household in contrast to a single person.

With any divorce agreement, regardless of the money being involved, it is best to consult a good divorce lawyer. A person who knows how to deal with financial settlements can help couples in a number of ways. Seeking consultation from a professional in this matter can yield a number of long-term and short-term benefits to both the parties. Divorce is usually an emotional decision and individuals do not take into account taxes and do not give this aspect much importance. However, it is a big source of worry later. Tax issues can greatly impact the overall settlement agreement. There are cases when one spouse is clever enough and lets the other partner drown in taxes. There are also cases when both the partners pay a hefty amount in taxes because of their previous lack of knowledge. While many laws are being made and some are under consideration regarding divorce financial settlement agreements, it is always better to be cautious beforehand in order to avoid any negative consequences in the future.