Taxes are a necessary consideration when dealing with a variety of divorce related issues including, the sale of a residence, child custody, and alimony, etc. It is therefore important for anyone considering or involved in martial litigation to have at least a basic understanding the tax implications of divorce. Please note that I am not a tax attorney. If you have a serious questions tax issues specific to your circumstances then it is important to consult with a CPA or an independent tax advisor. That said, it is my goal here to give you an overview so that can have a basic understanding of the different issues that can arise.
The first issue relates to child custody and how that impacts the dependency exemptions claimed by the parents. Under our laws the custodial parent is entitled to the dependency exemption. This means that the parent having primary legal custody will be the parent allowed to claim claim the child for a deduction at the end of the year. The noncustodial parent, despite child support, will not be entitled to the dependency exemption. However, the parties can reallocate this dependency exemption if the agree to do so in writing. If for example, in a settlement agreement the parties agree that the noncustodial parent is entitled to the deduction the IRS will honor that so long as the agreement is reduced to writing and submitted with the annual filing to the IRS.
Secondly,it is important to understand that child support payments are not deductible for the party paying the support, and not considered income for the party receiving the support.
Next, beginning in 2019 the tax treatment of alimony payments changed substantially. Prior to 2019, alimony payments were deductible meaning the spouse paying alimony could take an annual deduction for the amounts paid and the spouse receiving alimony had to claim those payments as taxable income. However, this is no longer the case. Alimony payments are now treated the same as child support payments. The spouse paying alimony will no longer get a tax deduction for those payments and the spouse receiving alimony no longer has to claim that money as taxable income.
Continuing, it is common for courts to divide marital property in a divorce which can involve the retitling of assets. This will generally be a nontaxable event. If, for example, a piece of property was previously titled in the name of one spouse, but as a result of the divorce order or agreement, that property is transferred to the other spouse, then that transfer itself is not going to be taxed. No gain or loss on the property will be realized at the time of the transfer. However, the individual receiving the property will assume the same cost basis that the transferor held. Generally speaking, when you purchase a piece of property, the purchase price is your cost basis in that property. If the property appreciates or depreciates after purchase, we calculate the gain/loss by looking to the difference between the cost basis and the sales price when disposed.
When property is transferred to a spouse by divorce order, the receiving spouse will assume the same cost bases held by the transferring spouse. If the spouse receiving the property later sells or disposes of that property, then they would have to calculate their taxable gain/loss based on the cost basis they inherited from their spouse.
Continuing, often times in a divorce the parties must sell the former marital residence, either by agreement or by order. While the sale of a primary residence can trigger taxable gain, the first $250,000 of gain is going to be excluded for single taxpayers and $500,000 for married taxpayers. For most individuals, the amount of the exclusion will exceed the amount of any realized gain.
Another area ripe for tax questions involves qualified domestic relations orders (QDRO). These orders deal with pension plans, 401ks, and other retirement accounts. Generally any early withdraw from such accounts can trigger taxes and penalties. The QDRO however, allows the money to be transferred to the other spouse without triggering tax consequences. However, this only protects the transfer of money from one qualified account to another. Regardless of whether or not there is a QDRO in place, if one spouse pulls their money from the 401k or other retirement account, then that could be a taxable event.
Lastly the deductibility of attorney's fees can be a complicated issue. The IRS has said some fees are deductible while others are not so this is an area where you want to be sure you are discussing the particulars of your case with your tax preparer. Generally speaking attorney's fees for personal expenses and divorces are not deductible. However in certain situations these fees are deductible if the dispute that the attorney is representing you on involves issues of alimony, the protection of property or income, or tax advice.