Is a Divorce Settlement Taxable?
Filing taxes can be such a hustle especially if you have to factor in divorce settlements. After the divorce process is finalized there is a big shift in assets and liability of the household. Tax considerations have to be made to factor in those changes.
Some parts of the divorce settlements are taxable while others are not. For instance, if there is alimony settlement the party paying the alimony gets a tax deduction. Furthermore, the amount is taxable to the individual receiving it. If a couple that undergoes divorce have children, then child support is normally included in the settlement.
The amount of money to pay for child support is usually not deductible. Property is also part of the settlement amount as couples are required to divide their belongings fairly. Parts of the divorce settlements have significant tax implications.
Alimony and its effect on taxes
Alimony is also another major issue that can have drastic tax consequences after divorce. Typically, the alimony amount is taxable as ordinary income to the recipient and is deductible to the remunerator.
However, it is also common for a spouse to make an agreement in the contract to prevent alimony payments not to be taxable or deductible to any party. Such an agreement can be beneficial to both parties as far as their income is concerned.
The critical factor to observe is the net value of the alimony after tax to the receiver and the amount that could be saved by the remunerator in taxes. If the overall amount of the tax savings essentially outweighs the tax liability then the spouse can negotiate for the amount to be non-taxable on the receiver as well as non-deductible on the payer.
Otherwise, as a couple, you can agree to pay or receive the alimony as a fixed aggregate amount or instead of the alimony agree for one partner to take a bigger part of the family properties in equitable distribution. This way there will no tax event that will have occurred hence no tax implications whatsoever.
Tax consequences in the initial year of the divorce
After the initial year of divorce or when your marriage legally ceases to exist, you will not able to file your taxes under the “Married Filing Jointly” clause. This can significantly increase your tax obligations. The increase in tax liability might be as a result of;
If you decide to sell or move out of the matrimonial house, major tax shelters can cease to be applicable to you. The tax shelters include real estate taxes and mortgage interest.
In the event that alimony is awarded in the divorce settlement, then either you or your former partner will have to pay additional taxes on this amount.
After the divorce has been finalized one of you will lose the privileges of deducting any if not all of your kids as dependents.
Property settlement Clause
This is one section that might have the biggest tax implication upon your divorce. This is because there are many factors that have to be considered to arrive at a fair property settlement.
One of the factors to be considered is whether the property is personal or community property. The other factor is whether the property should be divided equally or equitably depending on the outcome of the divorce rulings.
Tax implication on community properties
Division of properties during a divorce is usually governed by local state laws. Some states enforce common property laws while others enforce community property laws. Community properties are those assets that are co-owned by both partners during their marriage.
Nine states have already passed this law into a statute. The other states also consider community property of purpose of division during a divorce or for tax purposes. The income of the couples getting divorced are regarded as community property hence are shared equally between the individuals. Assets that are purchased by one party during the marriage with income earned during the marriage are also regarded as community property.
It is a requirement in almost all state for parties getting a divorce to disclose all relevant information in order to divide the property. To ensure full disclosure on part of the clients even intangible assets such as goodwill, patents or intellectual properties are considered.
Transfer of properties during the marriage is also a major factor that can cause tremendous tax implication. Many if not all states give legal rights in terms of sharing community or family properties during and after a divorce. However, the level and scope of those rights might vary from one state to another.
Marital property laws and their implication
Marital property laws are generally referred to as the equitable distribution laws. The courts base their decisions regarding what is just, reasonable, fair and equitable to divide the property. The courts can decide to award one partner a portion of the property or none at all.
The judges under this law are governed by factors such as the individual earning power of each spouse, the marriage period, the responsibility of each spouse in raising the kids, debts, and tax implications of the asset’s divisions, additional factors to be considered include;
● Whether there is a prenuptial agreement
● All the assets obtained during the marriage but are not covered in the prenuptial agreement are also subject to division.
● The source of the income used to purchase the assets
No matter the circumstance of the property transfer it is important that it happens in a way that will result in no taxable gain or tax liability. This is so because there are no property tax marital deductions are permitted for transfers to a divorced spouse. Furthermore, the person transferring the property will not wish the transfer to be included in their taxable property.
The rule of thumb under Sec. 1041(a), is the transfer of an asset to a former partner incident to a divorce will not cause the recognition of a tax gain or liability. The transfer of the assets is incident to a divorce if the transfer happens within 12 months after the date on which the marriage or relationship ceases. This requires that the transfer;
● Happens not more than 6 years after the date on which the marriage ceases to exist
● Is pursuant to a separation or divorce instrument
Tax implication on dependency deduction
When considering dependency deductions after divorce it is important to look at where the biggest tax saving benefits occur. This can be done by considering the benefits of an individual spouse taking the deductions or splitting the amount between yourselves. No matter the circumstance of the divorce, it is better for the couple to get a certain amount of tax benefit for child custody.
For instance, the couple agrees to joint custody, where one couple takes some of the children while the others stay with the other partner then there can be a tax cut that can be utilized. If you and your partner have an uneven number of kids, you can opt to share the kids equally and then alternate the other child in equal periods.
Generally, under the law, the partner who has the primary custody of the children is the one who is entitled to claim all of them for tax deductions. This can often lead to a wasted deduction if the custodian has little or absolutely no income that can cause any tax liability.
In such a case, look for the benefits that will accrue in the long run. For example, if you are the primary custodian then you can form an agreement with your partner to surrender their claim if they will have a tax benefit.
This is because if your partner is well off financially, then they will have to pay more on child support. Alternatively, if you are getting alimony which is taxable, then you can use the dependent claim to offset the alimony.
Tax implication on home loan interest and property tax deductions
Interest on home loan and tax deductions are tax advantages that are normally enjoyed when you still live under one roof. The tax benefits can be lost after divorce as one partner may eventually move out of the house.
The partner who moves out is discontinued from enjoying such shelter unless they negotiate on certain household items to act as compensation for the loss of the benefits.
In case one partner decides to sell the house, then there are several tax issues that they can consider depending on the circumstances prior to the sale. The tax issues include;
● If they still residing in under the same roof while sharing all the interim expenses pending the divorce settlement, then they can agree among themselves. This can happen until the date that one partner will eventually vacate the house. In such a case, it is paramount to set a precise date that the other partner is expected to leave the house in the divorce settlement.
● If the house is sold within the year of divorce or in the following years, the partners can come to an agreement to divide all the tax deductions and mortgage interest that is paid on the house up to the date of its sale.
● If it is only one spouse residing in the house prior to its sale and he or she is the one taking care of the mortgage and other taxes, then it is only fair that they get all the deductions in their tax returns.
Tax implications of a spousal buyout
It is common for spouses to buy out each other’s equity interest in the house or business that they were both sharing before the divorce. Whenever such a thing happens, the spouse who agrees to buy out the other partner usually has fewer funds to implement the buyout.
At this point, the partner will enter into a mutual agreement where the spouse who buys out the other will pay the buyout price in installments over a specified period after the divorce.
The important factor to consider here is that in the payment agreement, the party must specify that the property in the buyout is in equitable distribution and is incident to divorce. The buyout transfer will then be considered as tax-free according to the IRS regulation Section 1041.
In such a case, the buyout payments have to be completed within 6 years after the divorce decree for it to be regarded as payment “incident to a divorce.”
Tax implication on child support
If a divorce occurs and children are involved the court usually grants some amount of money for the upbringing of the children. This amount is usually referred to as child support, the amount is not considered ordinary income to the party who receives the money and hence it is not deductible. The mount has no tax implication whatsoever under the law.
Tax implication on the transfer of joint property
There are basic guidelines that are usually considered when the property has been transferred from one person to another before, during or after the divorce. These guidelines include;
● The size of the property to be transferred against the spouse’s current wealth
● The relationship of the parties involved at the time of the transfer
● Whether there was consideration involved during the transfer of the property in question
● The source of the property in question
● The period that has elapsed between the divorce and the transfer of the property
● Whether the transferor of the property still retains the rights of ownership of the property transferred. (this is commonly referred to as the illusory or revocable transfer.)
Several non-liquid assets have a major impact on the taxes upon their transfer from one spouse to another in divorce. The properties include but not limited to;
● Stock option plans
● Life insurance and retirement annuities
● Thrift saving Plans
● Brokerage funds
There is always a tax or penalty as a consequence of borrowing or taking a distribution from the above asset class. However, some of the above assets can be transferred without incurring any penalty or tax but most of them will require a Qualified Domestic Order (QDRO) for the transfer to be non-taxable or penalty free.
Taxable Divorce Issues Lawyer Free Consultation
If you have a question about divorce law or if you need to start or defend against a divorce case in Utah call Ascent Law at (801) 676-5506. We will help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506