Navigating the Tax Implications of Divorce: What Couples Need to Know

Divorce is a significant financial event, often bringing complex tax challenges that require informed planning and strategic decision-making. Whether it’s understanding how your income, deductions, and filing status may be impacted or navigating the division of assets, being informed is crucial to protecting your financial future.

Here are insights into the tax implications of divorce and practical strategies to manage the financial changes accompanying it.

Understanding Filing Status Changes

One of the first tax considerations during a divorce is determining your filing status. Your marital status as of December 31 determines your filing status for that tax year, directly impacting your eligibility for tax benefits and deductions and shaping your overall tax liability.

• Married filing jointly : This status often provides the most tax benefits, like lower rates and higher deductions, but it’s only applicable if your divorce is not finalized by year-end. If the divorce is finalized at any point before year's end, they would need to file as "single" or "head of household" if eligible, which are generally less favorable.
• Single : Once your divorce is finalized, this becomes your default filing status unless you qualify for head of household.
• Head of household : If you have a dependent child and meet specific criteria, you may qualify for this status, which offers better tax rates and a higher standard deduction than filing as single.

Spousal Maintenance and Tax Implications

The treatment of spousal maintenance (also known as alimony) has changed significantly at the federal level under the Tax Cuts and Jobs Act (TCJA) of 2018. For divorces finalized before 2019, spousal maintenance payments are deductible by the payer and taxable for the recipient. Divorces finalized after 2018, however, fall under the TCJA’s updated rules, meaning these payments are neither deductible for the payer nor taxable for the recipient.

• For divorces finalized before 2019 : Spousal maintenance payments are deductible by the payer and taxable income for the recipient.
• For divorces finalized on or after 2019 : Spousal maintenance payments are not deductible by the payer and are not included as taxable income for the recipient.

Understanding how these changes apply to your situation can help you negotiate fair agreements and plan for their tax impact. It is important to note that some states did not elect the new federal rules and as such, may still record payments as taxable income to the recipient and allow a tax deduction for the payor at the state level.

Child Support vs. Spousal Maintenance

It’s important to distinguish between the types of financial payments from one spouse to another for support purposes, which may have different tax treatments:

• Child support : These payments are not deductible by the payer or taxable to the recipient, but they were prior to 2019. Ensure your divorce agreement separates child support from spousal maintenance to avoid confusion. Mislabeling child support as spousal support may lead to tax complications, like improper taxation on payments that should remain non-taxable.
• Spousal maintenance : Depending on the timing of your divorce, spousal maintenance may still carry tax implications. Consult a tax professional to confirm your obligations.

Division of Property

Dividing assets during a divorce has important tax consequences:

• Property transfers : Property transfers between spouses as part of a divorce settlement are generally tax-free. The recipient spouse takes on the transferor’s original tax basis in the asset, meaning potential capital gains taxes may apply later when they sell.
• Retirement accounts : Splitting retirement accounts requires a Qualified Domestic Relations Order (QDRO) to avoid penalties. The QDRO specifically applies to qualified accounts like 401(k) plans and pensions, and ensures funds are transferred without triggering tax consequences or early withdrawal penalties. These penalties, which can be as high as 10%, are particularly significant during divorce as they can severely reduce the funds available for retirement or immediate financial needs. Consult a financial advisor to understand how account transfers impact your tax situation and long-term retirement plans.
  • Careful consideration should be given to employer sponsored plans before rolling over to an IRA. For receiving spouses under age 59.5, QDROs can provide for an exception of 401(k) distributions from the 10% early withdrawal penalty, though note that income taxes will still apply. However, if the 401(k) funds are rolled into an IRA before distributions are taken, the early withdrawal penalty applies along with the taxes, as the QDRO exception does not extend to IRAs.
• Sale of marital home : There are ownership and use tests that allow for a $250,000 capital gains exclusion per spouse. If one spouse keeps the home, they inherit the original cost basis and future capital gains exposure. A delayed sale may still qualify for tax exclusion if structured properly.
• Business transfers : One spouse may buy out the other’s interest in a jointly owned business. This is generally tax-free when incident to divorce. The receiving spouse assumes the original cost basis and tax liability upon future sale. Any future business income is taxable to the recipient.
• Investment and stock transfers : The transfer of stocks, bonds, or other investments between spouses are tax-free if part of a divorce settlement. It is important to remember that the recipient inherits the original cost basis and will be responsible for capital gains taxes upon future sale.
• Debts and liabilities : Common marital debts include mortgages, loans, and credit card balances. If one spouse assumes the mortgage, they may deduct mortgage interest if they continue making payments. Debt forgiveness (e.g., in cases of foreclosure or settlement) could result in taxable cancellation of debt income.

Most property transfers are tax-free at the time of transfer when part of a divorce agreement. However, there are tax implications that could reduce the net effect of any agreement to the receiving spouse if not considered during negotiations. When evaluating settlement options, it is vital to also understand what the property division looks like on an after-tax basis.

Tax Credits and Deductions

Divorce can affect your eligibility for various tax credits and deductions:

• Child tax credit : Only the custodial parent can claim this credit unless a written agreement states otherwise. In such cases, IRS Form 8332 is required to transfer the credit to the noncustodial parent. Make sure your divorce agreement specifies who will claim the credit.
• Dependent care credit : If you pay for childcare so you can work or look for work, you may qualify for this credit, but only if you’re the custodial parent.
• Education credits : Tax benefits like the American Opportunity Credit or Lifetime Learning Credit can only be claimed by the parent who claims the child as a dependent.

Homeownership and Mortgage Deductions

If you own a home together, the division of mortgage interest deductions and property taxes can become complicated. If one spouse keeps the house and continues making mortgage payments, they may claim the full deduction.

To avoid disputes, shared payments should be documented in writing, specifying each party’s contributions and the agreed allocation of deductions. Alternatively, if both parties agree to split the payments, each may only deduct their respective contributions, which must be documented.

• Mortgage interest deduction : Only the person responsible for paying the mortgage can claim the deduction. If payments are shared, ensure both parties understand how the deduction is divided.
• Property taxes : Similar rules apply to property tax deductions. Coordination is key to avoiding disputes and ensuring both parties receive their entitled benefits.

Health insurance and medical expenses

Divorce can lead to significant changes in health insurance coverage and medical expense deductions:

• COBRA coverage : If one spouse was covered under the other’s employer-sponsored health plan, COBRA allows for continued coverage temporarily. Be aware of the costs and time limits involved.
• Medical expense deduction : You may qualify if your out-of-pocket medical expenses exceed 7.5% of your adjusted gross income. Keep detailed records of the costs incurred before and after the divorce.

Planning for Your Post-Divorce Tax Situation

Proactive planning is essential to navigate the tax implications of divorce effectively:

• Update your W-4 : Adjust your withholding to reflect your new filing status and avoid surprises at tax time.
• Review your estate plan : Update your will, trusts, and beneficiary designations to reflect your post-divorce wishes and ensure that tax-efficient strategies are included.
• Maximize retirement contributions : If you’re behind on retirement savings due to the divorce, consider contributing to tax-advantaged accounts like 401(k)s or IRAs to rebuild your financial security.

Work with Professionals

Divorce often requires collaboration with professionals who can guide you through tax and financial complexities:

• Certified Divorce Financial Analyst :  The primary role for a CDFA® professional in the divorce team is to analyze the divorce settlement and help divorcing couples and their legal counsel understand the financial impact of their settlement in the short and long-term.
• Tax advisor : Ensure compliance with tax laws and identify strategies to minimize tax liabilities.
• Financial planner : Create a post-divorce financial plan that aligns with your long-term goals and accounts for tax considerations.
• Mediator : If disputes arise over tax or any other issues, mediation can help both parties reach amicable solutions.

Final Thoughts

Navigating the tax implications of divorce requires careful planning and informed decision-making. By understanding how taxes affect spousal maintenance, child support, property division, and other key areas, you can protect your financial interests and move forward with confidence.
Collaborating with trusted professionals and staying informed about tax laws will empower you to make sound financial decisions during this challenging time. With the right preparation, you can lay the groundwork for a more secure financial future.

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