Tax Consequences in Divorce

People often overlook the important tax implications of getting divorced.  They’re usually focused on child custody issues or division of property and fail to understand or bring up important issues that will determine the ultimate determination of how taxes will be attributed and assigned as a result of their divorce.

Important areas to think about are: division of assets, support, income tax filing, division of retirement benefits and, if applicable, innocent spouse relief.

As a foundational issues, the Supremacy clause of the U.S. constitution means that Federal Tax law will govern even in state court where divorces are heard.  That means a state court judge may not validate any agreement that contravenes federal tax law.

Let’s look at how these rules affect different parts of a divorce.

  • Division of Marital Property
  • No gain or loss.  Generally, no gain or loss is to be recognized when assets are transferred because of a divorce.  There are some rules to follow when determining whether the “transfer” was a part of the divorce.  They are:
    • The transfer is required under the divorce decree or divorce or separation agreement.
    • The transfer occurs within six months of the marriage ending
    • There is a presumption, although subject to rebuttal that a transfer was related to the divorce if it occur within six years but the party can show there were legal or business reasons for delaying the transfer.
    • Exceptions:  There are some exceptions that apply to this rule, such as where the spouse is a resident alien, some transfers related to trusts and some stock redemptions.
  • IRS Exemptions and Filing Status
    • Clients are obviously eager to take advantage of a “head of household”, or “single” filing status, but it is very important to be careful at this stage.  The IRS is very clear in its rule that parties who are still married (ie; there is no final divorce decree) must file as “Married filing  jointly” or “Married filing separately”.  The ability to file as head of household or ‘single’ can only be used after a final decree of divorce or legal separation is obtained, before the last day of the tax year.  (It’s also important to understand that parties may revise prior year tax returns if an “annulment” is given by the court since an annulment states that a valid marriage never existed.
  • Alimony, Child Support
    • One of the tax related issues in divorce that upsets parties the most is the treatment of child support payments.  Child support is not deductible to the person paying the support (the payor).  Calculating this tax may be an important factor in determining “net income”
    • Alimony is generally treated differently than child support for tax purposes.  In this case alimony is deductible to the payor, and the recipient must include it as income.