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A common question asked when representing clients in a divorce is how do I file my income taxes during the pendency of the divorce. If you are separated from your spouse or in the process of a divorce, you can not file as a single taxpayer if you are still legally married at any time during the tax year. You have the option of either filing jointly with your spouse or filing separately. Normally filing jointly is more advantageous and eliminates the need to allocate income and deductions among the two taxpayers.
The tax aspects of any property settlement agreement should always be carefully considered. If properly considered, a property settlement agreement can not only end up being financially equitable to both parties but also can be tax efficient as well.
The property you receive in a divorce settlement is not taxable income. But if you decide to sell the property later, there may be capital gains taxes to pay. Here is where your once equitable property settlement can turn unfavorable. The best way to describe this is with an example. Suppose that at the time of the divorce, you and your spouse own stock in ABC Company and XYZ Company, each valued at $100,000. Each of the parties receives all of the stock in one of the companies so things seem to be equitable. However, assume that several years later both parties need to sell their stock. You find out that ABC company stock was purchased originally for $30,000 which is your cost basis for tax purposes. XYZ Company stock was purchased for $80,000. If the stock in ABC company is sold for $100,000, you have to pay capital gains tax on $70,000 or $10,500. The net amount received from the sale of the ABC company stock is $89,500. If the stock in XYZ company also sells for $100,000, there is a $20,000 capital gain or $3,000 in tax. The net amount received from the sale of XYZ company stock is $97,000. How fair does the property settlement seem now?
If you receive a distribution from a retirement plan [401(k), 403(b), 457 plan], you will be taxed if you withdraw the money rather than rolling it over to another qualified plan or IRA account. The penalty for early withdrawal is usually waived if the withdrawal was pursuant to a Qualified Domestic Relations Order (QDRO) incident to the divorce. Even though potentially taxable, distributions from a qualified plan still may be a good way for the lower income spouse to receive cash but always make sure that the tax consequences are considered during the negotiations.
Dependency exemptions should also be carefully considered. The law says that the exemption goes to the custodial parent unless the Judgment of Divorce states otherwise. The current trend is for parents to alternate years claiming the children as exemptions since normally both parents are financially supporting the children. In prior years, the IRS just required a copy of the Judgment of Divorce be attached to the tax return of the noncustodial parent to prove they were entitled to the exemption. For a Judgment of Divorce entered after 2008, the IRS requires the submission of IRS Form 8332 or similar statement from the custodial parent. The IRS will no longer accept copies of the Judgment of Divorce.
Finally, always consider the tax consequences of spousal support payments. Assuming the spousal support is paid in periodic payments rather than a lump sum, the payments are tax deductible to the spouse making the payments and are including as taxable income to the spouse receiving the payments. In many cases where the paying spouse is a high income taxpayer and the spouse receiving the payments is a lower income taxpayer, the paying spouse can afford to make large spousal support payments due to the deductibility of the payments. Also, if it comes to either selling an asset that would result in a loss or paying spousal support, a few years of spousal payments may be a good alternative to losing money on the sale of an asset to create liquidity.
This is just a summary of some of the more common tax issues in divorce. We would be glad to discuss the tax aspects of your particular situation with you.
Curtis & Curtis, P.C. is a full service law firm located in Jackson, Michigan providing superior legal services and advice to individuals, families and businesses throughout mid-Michigan since 1901.
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