In the first few months of the year, as divorces are pending and couples are fighting whether they must file a joint tax return, I have had to advise numerous clients as to their options and what choices might be the most financially advantageous to the parties. I have also seen lots of really poor advice scattered around online through Facebook and other places.
Which Filing Status should I use?
Your marital status for the tax year depends on the day you obtained your final decree of divorce or separate maintenance generally however; if you were separated (meaning spouse did not live in the home) the last six (6) months of the year. Federal laws do not control marriage or divorce, it is all controlled by state law, so the IRS determined their own definitions. You are “unmarried for the whole year” if you have obtained a final decree of divorce or separate maintenance by the last day of your tax year. If you are unmarried, the choices given by the IRS for filing status are “single, head of household, or qualifying widow(er).” If you are still married at the end of the year, you will file either Married Filing Jointly (MFS) or Married Filing Separately (MFS). The IRS (Federal Law) maintains jurisdiction over tax returns. HOWEVER, the Court can order that if filing separately financially disadvantages the other spouse and you did not have good cause to file separately that you may have to pay over to your spouse the amount that they lost by not sharing in the benefits of jointly filing. If you don’t have good cause to file separately, almost always, filing jointly is better for you financially. There are exceptions to this. If your spouse has been cheating on taxes, you have good reason to believe the spouse is involved in a criminal enterprise, or the spouse has created a tax debt for the purpose of making you split the cost, then filing separately may be a good idea. Filing separately though may cause you to lose several tax benefits, especially if you have children. You should consult with a tax adviser or an attorney if you believe this is a concern.
Dependency Exemptions for Children
“Who is supposed to claim the kids?” That must be the question asked most often in the middle of a divorce or right after the decree has been entered. The basic IRS rule for claiming a child exemption requires that a child be under 19 years old (or under 24, if a student) or any age if the child is permanently disabled. A child is considered a “qualifying child” for exemption purposes of the custodial parent. A custodial parent is “the parent with whom the child lived for the greater number of nights during the year.” The other parent is the noncustodial parent. The entire rule is listed in 26 USC 152(c). To get really to the grind though, no matter what anyone tells you, the custodial parent ALWAYS should list their children on their tax return. Generally there are up to 7 tax benefits that a parent may receive in claiming a child. ONLY two (2) are transferable to the non-custodial parent and that must be done with IRS Form 8332. The court may order that the non-custodial parent receives Child A & B every other year for tax purposes. The problem is that the procedure for the non-custodial parent to claim those children is not explained to the non-custodial parent very well, if at all. The result is non-custodial parents unknowingly commit tax fraud and the custodial parents leave thousands of dollars in Uncle Sam’s pockets. If it has been ordered that the non-custodial parent gets to claim the children for tax purposes, then the custodial parent must execute IRS Form 8332 and provide that to that non-custodial parent or else the non-custodial parent may be able to move for a Show Cause Hearing (contempt). If it has been ordered that the non-custodial parent may claim the children, doing so without an executed IRS Form 8332 may be tax fraud. When you claim your children without the form, you are telling the IRS, under the penalties for perjury, that the children lived with you the majority of the year. Different states have different rules for why a child may be ordered claimed by the non-custodial parent. Indiana’s intention was to really milk the government for all that was possible for the benefit of the child and that really comes down to “Marginal Tax Rates” (tax rate for each extra dollar earned) and is there sufficient income to receive the full Child Tax Credit of $1,000. So let’s study a real example – suppose a custodial mom earns $10,000 per year raising 3 young children at home. She really is working part time because the kids take up all of her time, and using a day care on 3 kids would just be too expensive. Non-custodial dad though earns $65,000 per year. Mom’s marginal tax rate is 0% – she pays no taxes. Dad’s marginal tax rate though is 25%. Every year the value of the exemption changes but it was $3,950 for the 2014 tax year. The exemption is the amount taken off the top of a person’s gross income.
|Less deduction||-$9,100.00 (HOH)||-$6,200.00 (single)|
|Less Exemptions||-$3,950.00 (just self)||-15,800.00 (4 x $3,950)|
|Adj. Gross Income||-$3,050.00||$43,000.00|
Each child to dad, due to his marginal tax rate of 25%, is worth $987.50 but to mom they have zero value. Mom also earns too little to receive the Child Tax Credit of $1000 per child but dad does earn enough. In that particular case, it would not make any sense for the mother to claim the Exemption and Child Tax Credit. She would receive a sizable refund though for Earned Income Credit whereas Father is not entitled to any Earned Income Credit because of his income being too high.
The IRS defines alimony as “a payment to or for a spouse or former spouse under a divorce or separation instrument. It does not include voluntary payments that are not made under a divorce or separation instrument. Alimony is deductible by the payer and must be included in the spouse’s or former spouse’s income.” Child support, noncash property settlements, payments that are your former spouse’s part of community income, payments to keep up property owned by the paying spouse and use of the property owned by the paying spouse are NOT considered alimony for IRS purposes. Indiana does not have “Alimony” but we do have “Maintenance” which is basically the same thing and follows the IRS tax rules for alimony. If it has been ordered that you are to receive maintenance, that is Miscellaneous Income you must report on your tax return. The payor will deduct that loss off the schedule A of the tax return. Important to note in the decree what is maintenance and what is not. Scheduled payments that are just a split from the marital estate is a “present property interest” and not maintenance. There are no tax ramifications of making those scheduled payments.
The IRS further clarifies that “a payment to or for a spouse under a divorce or separation instrument is alimony if the spouses do not file a joint return with each other and all the following requirements are met:
- The payment is in cash [including electronic transfer, check or money order]
- The instrument does not designate the payment as not alimony.
- The spouses are not members of the same household at the time the payments are made. This requirement applies only if the spouses are legally separated under a decree of divorce or separate maintenance.
- There is no liability to make any payment (in cash or property) after the death of the recipient spouse.
- The payment is not treated as child support.
Retirement Accounts, QDROs, and IRAs
This is very important for a person who is receiving a split off of their spouse’s retirement to take some concern. If the receiving spouse simply rolls it over into their own plan, there will be no tax owed; however, if the receiving spouse uses that money, it will become taxable and potentially also carry penalties with it. Please speak with your tax adviser or financial adviser, it may be recommended that a receiving spouse immediately roll it into their own IRA. If you need access to cash quickly, look into how you might be able to borrow from the IRA and pay it back over time without suffering the tax consequences or the penalties for just using the money.
Capital Gains and Losses
Some assets that may get transferred in the divorce may carry Capital Gains or Capital Losses. The determination of the tax complications would be best figured by a tax professional familiar with divorce. Think of these as homes, real estate, rental properties, stocks, bonds, mutual funds, shares of company stock of a closely held company. The length of time these have been owned also will make a significant difference to know if they are short-term or long-term capital gains. Long term gains are taxed at a much lower rate to encourage people to hold the investments longer while short-term gains are taxed at your regular income tax rate. If you have losses, up to $3,000 be deducted in their current year, any excess is carried into future tax years. If your last joint tax return had losses that were still being carried over, it should be addressed in your divorce decree as those losses stay with one person until it is exhausted. If you had losses being carried forward for the next 10 years and your marginal tax rate is 25% then that can make a significant difference. $3,000 x 25% = $750 x 10 years = $7,500.
Property Settlements and Sale of Joint Property
There is no recognized gain or loss when you transfer property between spouses or former spouses if the transfer is part of a divorce. Even if the transfer was “in exchange for cash, or the release of marital rights, the assumption of liabilities, or other consideration.”
Donations and Other Deductions
If you have both donated money to charity, a decision as to who is claiming those donations, or at least the portion of those donations needs to be determined if it is not included in your divorce decree. Just like Capital Gains and Losses, excessive prior year qualified contributions can be carried forward for up to 5 years.
Medical expenses, Property Taxes, and Mortgage Interest, for those that are able to file a schedule A, should also be determined in the divorce decree so as to prevent one or both parties from double dipping into the deductions.
The New Dilemma – The Affordable Care Act
This has been a new issue since the ACA (Obamacare) was enforced in Tax Year 2014 as employers have canceled their coverage of employees placing the burden on the employee to purchase health insurance from the market place. To qualify for any subsidy though, the tax return is the first place they look. To include children especially, you must be able to show that you would be the one claiming them in your home. Not that custody should be decided on financial grounds alone but if the parents are enjoying 50/50 time, the parent with the lowest income should go ahead and be considered the custodial parent for the purpose of receiving the highest subsidy possible for your children. Since the cost of insurance is figured into child support, financially it is in everyone’s best interest to figure the costs this way. Talk to the attorney though about whether it is in the best interests of the children just in case naming one parent over the other is strategically advantageous in the long term for custody or visitation.
Taxation is a specialized area of law. The assistance of an Enrolled Agent (tax adviser licensed by the Treasury Department), a tax accountant, or a CPA that handles tax matters (most CPAs do not do taxes).
Joseph Bryant is a Divorce Mediator, Paralegal, and Tax Adviser for Cogswell & Associates. You can connect with him on linkedin at http://www.linkedin.com/in/taxprojoe