Identifying the Tax Consequences of Divorce.
At some point you will have some basic issues regarding the tax consequences of your divorce. This material may provide you with some answers to frequently asked hypothetical questions, and may also identify some more complex issues that you may need to be made aware of. While it is important to have some basic knowledge, it is wise to seek the advice of a tax professional.
The following is not meant as tax advice, and we have no particular expertise in tax situations. You should seek advice from an independent tax professional. This material should not be relied upon since every situation is different and fact specific.
Divorce and Taxes
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Selling the Marital Home and Capital Gains
SALE OF MARITAL HOME
Selling the marital home is often the only option if both parties are to receive an equitable share in the distribution of joint assets, but the sale of a house can expose the owners to taxes.
CAPITAL GAINS
A couple who bought a house in the early part of the housing boom may face considerable capital gains because the stratospheric prices of the housing market moved the house far above what the couple paid for it. If a person realizes more than $250,000 (if single) or more than $500,000 (if married, filing jointly), the gain will be taxed at 8 percent or 18 percent, depending upon income.
EXCLUDING CAPITAL GAINS
Since 1997, each spouse may exclude up to $250,000 (or $500,000 as a couple) from any capital gains tax if the spouses have lived in the house for any two of the last five years. This capital gains exclusion can work against a single house owner who takes the house as part of the settlement, and then sells it later as a single person for more than $250,000. If the house sells for more than $250,000 over the price they paid for it, the owner will owe taxes.
ROLLOVER PROVISION
The rollover provision, which required taxpayers to roll the money from one house to a more expensive house, has been eliminated. Until 1997, a couple who wanted to claim the capital gains tax exclusion on a primary residence had to purchase a new home of equal or greater value than the one they sold. The rollover provision has been eliminated, so a divorcing couple can take the exclusion without buying another home.
PRIMARY RESIDENCE
In another situation, if a spouse moved out of the house before the divorce was final, and then ended up getting the house in the proceedings anyway, the person can still claim the house as a primary residence. While the sale of a primary residence can be sheltered from capital gains of up to $500,000, the sale of other real estate may result in taxable events.
Retirement Accounts
What about retirement accounts? What’s the best way to transfer funds from them incident to divorce?
Retirement accounts are an important to know exception to the tax-free transfer rule established in Section 1041 of the Internal Revenue Code. The best way to handle the transfer of funds from retirement accounts incident to divorce is to use a Qualified Domestic Relations Order (QDRO). This vehicle allows the distribution of the marital asset without damaging the integrity of the plan or the creation of a taxable event. A QDRO is a useful tool to designate a portion of a qualified retirement plan, and the associated taxes, to the other spouse. Benefits are taxed when distributions are made, not when the QDRO is established.
Failing to use a QDRO can result in the following situation: Spouse A receives a distribution from their portion of Spouse B’s retirement account, but since there’s no QDRO in place Spouse B is assessed for taxes on the distribution while Spouse A receives the income tax free.
QDRO’s are not required for the transfer of Individual Retirement Accounts (IRA’s). The transfer of an IRA pursuant to a divorce or separation agreement is not a taxable event (26 U.S.C.A.§ 408(d)(6)). If such a transfer is anticipated, it is imperative that language requiring such a transfer be included in the divorce agreement. Failing to have such language in the divorce agreement, or the premature transferring of an IRA, can result in the transferring party being assessed taxes as though they received a disbursement (including a 10% penalty for anyone under 59).
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
Claiming Dependents
Which parent gets to claim the child as a dependent?
Arizona has specific guidelines for the assignment of the federal tax exemption for dependent Children that are established in Section 27 of the Arizona Child Support Guidelines. Here is the relevant text from Section 27:
All the federal and state tax exemptions applicable to the minor children shall be allocated between the parents as they agree, or in the absence of their agreement, in a manner that allows each parent to claim allowable federal dependency exemptions proportionate to adjusted gross income in a reasonable pattern that can be repeated in no more than 5 years. This may be done by allocating claiming of the children or claiming of specific years. To implement this provision, the proportionate share of the combined adjusted gross income nearest fraction with a denominator of no larger than 5 (i.e. ½, 1/3, 2/3, ¼, ¾, 1/5, 2/5, 3/5, 4/5).
For illustrative purposes, assume father earns $60,000 and mother earns $40,000 of the combined adjusted gross income of $100,000. Father’s share of the combined income is 3/5. If father earned $30,000 and mother earned $20,000, then 3/5 would still be the fraction with a denominator of 5 or less that comes closest to father’s share of the parents’ combined adjusted gross income. The dependency exemption shall therefore be allocated utilizing this fraction. If a party who is otherwise entitled to the dependency exemption would derive no tax benefit from claiming it in any given tax year, then the entire exemption for the tax year, and not just the share indicated by the preceding sentence, may be allocated to the parent who would derive a tax benefit for that tax year. An Internal Revenue Service form 8332 may need to be signed and filed with a parent’s income tax return.
The court may deny the right to a present or future tax exemption when a history of nonpayment of child support exists. The allocation of the exemptions may be conditioned upon payment by December 31 of the total court-ordered monthly child support obligation for the current calendar year and any court-ordered arrearage payments due during that calendar year for which the exemption is to be claimed. If these conditions have been met, the custodial parent will need to execute the necessary Internal Revenue
Service form (Form 8332) to transfer the exemptions. If the non-custodial parent has paid the current child support, but has not paid the court-ordered arrearage payments, the noncustodial parent shall not be entitled to claim the exemption.
EXAMPLE: Non-custodial parent’s percentage of gross income is approximately 67% (2/3) and custodial parent’s percentage is approximately 33% (1/3). All payments are current. If there are three children, the non-custodial parent would be entitled to claim the exemption for two children and the custodial parent would be entitled to claim the exemption for one child. If there is only one child, the non-custodial parent would be entitled to claim the child two out of every three years, and the custodial parent would claim the child one out of every three years. For purposes of this section only, a non-custodial parent shall be credited as having paid child support that has been deducted on or before December 31 pursuant to an order of assignment if the amount has been received by the court or clearinghouse by January 15 of the following year.
Innocent Spouse Relief
Many individuals intentionally cheat on their taxes, and many more make mistakes in their interpretations of the tax code or the production of their returns. In the event that one spouse engages in improper behavior resulting in nonpayment or underpayment of taxes on joint tax returns, the other spouse may qualify for relief as an “innocent spouse”.
There are three major types of innocent spouse relief, one of which is specific to divorcing couples:
Innocent Spouse Relief (IRC §6015(b): This traditional innocent spouse relief is available to all joint filers where one spouse had no actual knowledge and no reason to know of a tax deficiency. A request for relief must be filed within two years of the first collection activity taken by the IRS.
Separation of liability relief (IRC §6015(c): This relief is available only to those who are divorced or separated for at least 12 months before applying for relief. The return must have been jointly filed, and the spouse must have had no knowledge of the incorrect item(s) on the tax return. The burden of proving actual knowledge is placed on the IRS. This form of relief is typically easier to obtain and allocates liability for the tax deficiency among the spouses based on who was responsible for the nonpayment or underpayment.
Equitable relief (IRC §6015(f): This type of relief is available to spouses who do not qualify under §6015(b) or §6015(c). Equitable relief is afforded to filers who are able to prove that it would be unfair to hold them responsible for the nonpayment or underpayment of the taxes.
How to Make an “Innocent Spouse” Claim
Those seeking innocent spouse relief can begin the process by filing form 8857 with the IRS. When this form is submitted individuals must submit evidence proving their right to relief. A divorce is one important piece of evidence that can be used when filing form 8857. Further, while those who are ending a marriage are specifically entitled to relief under IRC §6015(c), divorcing clients are not restricted to using only this provision of the Internal Revenue code to escape an unfair tax obligation.
The following factors are considered when determining the availability of relief:
- Knowledge,
- Economic hardship,
- Benefit,
- Compliance with tax laws,
- Tax liability attributed to non-requesting spouse,
- Marital status, and
- Spousal abuse
The innocent spouse rule is not only an important rule for protecting spouses from the malfeasance of one another, it also is important to subsequent spouses. Consider this scenario:
Spouses A and B were married for 15 years. Spouse A operated a small business which spouse B assisted with. Spouse A, primarily in charge of the business, handled all of the bookkeeping and regularly cheated on the business’s and the couple’s taxes. Spouses A and B divorced after 15 years, and shortly thereafter spouse B remarried a third party, Spouse C. Soon after B’s marriage to C, the IRS audited and prosecuted Spouses A and B for 15 years of unpaid and fraudulently reported taxes. Spouse B was unable to prove that he/she had been an innocent spouse, and now the community assets of Spouses B and C are able to be seized by the IRS.
Selling the Marital Home and Capital Gains
Sale of the marital home is often the only option if both parties are to receive an equitable share in the distribution of joint assets, but the sale of a house can expose the owners to taxes. Despite the collapse of the housing market, spouses still must consider the capital gains relating to the sale of homes. A couple who bought a house in the early part of the housing boom may face considerable capital gains because the stratospheric prices of the housing market moved the house far above what the couple paid for it. If a person realizes more than $250,000 (if single) or more than $500,000 (if married, filing jointly), the gain will be taxed at 8 percent or 18 percent, depending upon income.
Since 1997, each spouse may exclude up to $250,000 (or $500,000 as a couple) from any capital gains tax if the spouses have lived in the house for any two of the last five years. This capital gains exclusion can work against a single house owner who takes the house as part of the settlement, and then sells it later as a single person for more than $250,000. If the house sells for more than $250,000 more than they paid for it, the owner will owe taxes.
In order for the capital gains tax exclusion to apply the house must have been the principal residence for two of the past five years when it is sold. That means, effectively, that the house must be sold within three years after a spouse departs. It’s common these days in divorce for one of the spouses to move out of the house but to continue to own an interest in it for several years. Once a party is gone for more than three years, the house is no longer the principal residence. If it is sold at gain, taxes will be owed. However, if a spouse moves out and his or her former partner has the right to live in it pursuance to the divorce, that spouse’s residence in the house will be counted for calculating the two year requirement.
In another situation, if a spouse moved out of the house before the divorce was final, and then ended up getting the house in the proceedings anyway, the person can still claim the house as a primary residence. While the sale of a primary residence can be sheltered from capital gains of up to $500,000, the sale of other real estate may result in taxable events.
Rollover Provision
The rollover provision, which required taxpayers to roll the money from one house to a more expensive house, has been eliminated. Until 1997, a couple who wanted to claim the capital gains tax exclusion on a primary residence had to purchase a new home of equal or greater value than the one they sold. The rollover provision has been eliminated, so a divorcing couple can take the exclusion without buying another home.
Debt Forgiveness and “Phantom Income”
“Phantom income” is taxable income that the individual never receives as actual income, and it is particularly pertinent in divorce law. When large amounts of debt are at issue in divorce proceedings, often it is the intention of one of the parties to settle the debt for less than the total value presented to the court. It is vital that the concept of phantom income be understood in these situations.
When a debtor settles a debt for less than its value, the debtor receives taxable “phantom income” equal to the debt forgiven. The creditor essentially “pays” the delinquent borrower the amount of debt forgiven, and creditors send Form 1099-C to the debtor showing the amount of “income” that he or she received as forgiven debt. The debtor then must report this income to the IRS and pay taxes on it.
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
Division of Assets
Do I need to pay taxes relating to the division of our assets?
No, the general rule (IRS 1041) is that most assets can be divided between divorcing spouses without the creation of taxable events. Language should be included in the property settlement agreement citing IRS 1041. Here’s an example:
“The parties intend the distribution of property herein to be considered a property settlement and a transfer incident to divorce and, therefore, a non-taxable event under the current federal and state tax codes, including Section 1041 of the Internal Revenue Code. Neither party shall treat the division of property provided for herein as a sale or as giving rise to gain or loss for federal income tax purposes or as entitling a party to an adjustment in the basis for income tax purposes of any item or property retained, received or transferred by this Agreement. Should either party violate the provisions of this paragraph and thereby cause tax liability to the other party, the party causing liability shall hold the other harmless and pay all consequential liability of the other party”
Tax-free transfers can occur before the divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they are made “incident to divorce,” which means those that occur: within one year after the date the marriage ends; or within six years after that date as long as they are made pursuant to your divorce or separation agreement.
Stock Options
My spouse was awarded some of my vested stock options in our divorce. Who pays taxes on what and when?
The transfer of an interest in vested stock options incident to a divorce is not a taxable event. However, income is reported when the former spouse exercises the stock options. The specific issue of what taxes must be paid upon the exercising of an option is discussed later in further detail along with other capital gains and appreciated assets concerns.
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
Mortgage Interest and Real Estate Taxes
I no longer live with my spouse/family but my name is still on the mortgage on their house. Who gets to claim the mortgage interest and the real estate taxes?
When a couples’ “family home” (for IRS purposes) is jointly owned and the mortgage interest and real estate taxes are paid from a joint account there is a presumption that these payments are attributed to each party on a 50/50 basis. If the mortgage is paid by one spouse to help the other, it is sometimes called an “equalization payment”, and under IRS 1041 there are no tax consequences.
It gets more complicated when a home is jointly owned and these payments are paid directly by the non-occupant spouse. Half of the mortgage interest and real estate taxes is deductible to the paying spouse as an itemized deduction and the remainder qualifies as spousal maintenance (IRS alimony). The occupying spouse must report these amounts as income but is able to deduct the interest and taxes as an itemized deduction.
If the home is owned only by the occupying spouse but the non-occupying spouse is still obligated on the mortgage, the non-occupying spouse can only deduct the mortgage interest if a minor child of the marriage resides in the home. The non-occupying spouse cannot deduct any of the real estate taxes, since he or she has no ownership in the property.
Alternatively, if the non-occupying spouse solely owns the house and pays the mortgage interest and real estate taxes then those amounts can be deducted in their entirety as an itemized deduction. The occupying spouse would not have to report these amounts as spousal maintenance (IRS alimony).
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
IRS Developments and Changes
On July 25, 2011 the IRS issued Notice 2011-70, which made a significant change to the requirements for those seeking innocent spouse relief under (IRC Section 6015(f). In Notice 2011-70, the change made by the IRS is simple: they extended the eligibility period for those seeking equitable relief, lifting the previously enforced two-year limit. Under the new rules established, the IRS will consider equitable relief for:
Collection of tax debt as long as the collection period on the debt still remains open. IRC §6502 establishes a general 10-year statute of limitations for collection on tax debt, so the deadline is extended for the duration of this 10-year period.
A refund of tax debt as long as the statute of limitations on credits or refunds has not yet expired. IRC §6511 establishes a general statute of limitations for collecting refunds of the later of three years from the time the return was filed or two years from the time the tax was paid.
It is, however, important to note that these changes provide broader relief only to spouses seeking equitable relief and not to those seeking traditional innocent spouse relief or separation of liability relief.
Capital Gains Taxes and Appreciated Assets
The spouse who winds up owning an appreciated asset (fair market value in excess of tax basis) must recognize taxable gain when it is sold. In other words, if you are the one who ends up with appreciated assets like stock or real property, you’re on the hook for the built-in tax liability that comes with them. Thus, from a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that have not appreciated. Here’s an example:
Your divorce settlement calls for your spouse to receive all your long-held Apple shares. Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex keeps on rolling under the same tax rules that would have applied had you continued to own the shares (carryover basis and carryover holding period). When your spouse ultimately sells the shares, he or she (not you) will owe any resulting capital gains taxes.
Capital gains tax implications are very important to consider during divorce, as the difference between net-of-tax value and net value can be significant for many types of assets. Even seemingly minor items like sports memorabilia or antique furniture can trigger capital gains taxes, and equitable dissolution can be significantly thwarted by failure to consider capital gains tax implications.
Spousal Maintenance/ “IRS Alimony” Recapture
When structuring spousal maintenance agreements one should be conscious of the IRS alimony recapture rule (IRS 71(f)). The IRS alimony recapture rule forces the spousal maintenance payer to report as income the spousal maintenance payments previously deducted. If there is a decrease or termination of spousal maintenance (IRS alimony) during the first three calendar years, recapture rules apply if the spousal maintenance (IRS alimony) in the second or third calendar year is $15,000 less than in the prior year. The recapture provision may be initiated by one or more of the following:
Failure to make timely payments,
Change in divorce or separation agreement,
Reduction in spouse support needs, and
Reduction in payer’s ability to provide support
For example, if in the first year a payer pays $30,000 in spousal maintenance, then in the second year pays $20,000 in spousal maintenance, but in the third year makes a successful motion to modify the obligation because the payee has a new job and, as a result, only pays $4,000 in spousal maintenance ($16,000 less than the second year), the recapture rule is triggered. The payor must be prepared to report the first year’s and the second year’s formerly deducted spousal maintenance payments as income. And you might have thought you were doing client a favor by petitioning to modify the spousal maintenance obligation in the third year!
However, the recapture rule does not apply:
For payments made pursuant to a temporary order; If the payments terminate due to you or your ex’s death; Your ex’s remarriage prior to the end of the third year; and When the total payments made each year vary, for reasons not in your control, and are tied to a business, property, variable employment or self-employment. In these circumstances, the termination and variable amounts of alimony are foreseeable and assumed.
The easiest way to avoid the IRS alimony recapture rule is to avoid front loading spousal maintenance agreements. Consider increasing spousal maintenance payments over time, longer schedules of repayment, or tying the payments to uncontrollable income per exemption four above.
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