Not much is harder in life than going through a separation or divorce. Figuring out how to handle your taxes before, during, and after a divorce is right up there with the most difficult of challenges.
So, before you make big moves to separate or divorce, know the potential tax consequences, and take steps to protect yourself from further trauma and financial pain.
Here are seven tips on some of the most questioned tax topics for people who are divorced or divorcing:
When Are You Actually Divorced?
The IRS sees things differently about your divorce than you might, including the actual date of your divorce. Even if you get divorced January 1st of this year, you will still have to file last year’s tax return as married. This is because the IRS sees your status on December 31st of the prior tax year as the story for the whole year. On the flip side, if your divorce became final in December, you won’t be able to file as married even if that was your status for most of the year.
What Are Your Filing Options?
Even if you are legally still married as of the end of the year but divorce is impending, you may have some options in how to file for that year and can determine which route is most advantageous to both individuals. You could obviously file married filing jointly or married filing separately; however, in some cases, the head of household status – originally created for single taxpayers – might apply to you as well and could save you money.
To qualify as head of household, you have to be “considered unmarried” as of the end of the year (even if legally still married): you must have lived apart from your spouse for the last six months of the year, have paid over half the cost of keeping up your main residence (and it was the main home of your child(ren)), and be able to claim your child(ren) as your dependent(s) under the rules for children of divorced or separated parents. Also, you have to file a separate tax return from your spouse, even if you are still legally married.
The head of household route could significantly improve the overall tax outcome because of more favorable tax rates and higher thresholds for certain deduction items, so it’s worth checking into all of your filing options and determining what’s best for your particular situation.
Watch Out for Capital Gains Tax on the House
You don’t have to pay income taxes on assets that are transferred during a divorce. But keep in mind that if you do get the house in the settlement but want to sell, you will be subject to capital gains tax on the sale as a single person.
Normally, a married couple doesn’t have to pay taxes on a gain of up to $500,000 on their primary residence. If you are single, you can only exempt half of that. So if your house sells for more than $250,000 over what you and your former spouse paid for it, you will owe taxes, and the rate will depend on your income bracket.
Your Kids Aren’t Your Dependents…Unless the Court Order Says So
Custody agreements are often quite creative. The arrangements are varied compared to the old days, when mothers typically got custody of the kids and took them as dependents. Now, custody is often shared, and the right to claim kids as dependents must be stated in the decree.
Generally, you can claim the kids as dependents only if you were designated to do so by your separation agreement or divorce decree. When there is no such agreement or order, or when joint custody applies, the custodial parent is considered to be the parent who has physical custody of the child for most of the year.
What happens when you share custody equally? You will need to decide who claims the child and in what year, as you both can’t claim him or her as a dependent. If there is more than one child, couples will often split the dependency of each child between the two parents. For example, if you have two children, the mother can take one and the father can take the other as dependents.
Child Support Is Never Deductible
While alimony is considered a taxable event, child support is always non-taxable. This basically means that it doesn’t affect your taxes in any way. This can be troublesome for some who are making large child support payments to understand that there is no tax break. Likewise, the recipient of the child support payments does not have to report them as income.
It can be tempting for some to try to classify child support as alimony in order to get a tax deduction. This is never a good idea and can get you in a lot of financial trouble later. Remember, no matter how much you have to pay or for how long, you can’t deduct child support!
Alimony Affects Both Your Taxes
In 2017, if you are the person paying the alimony, you will get a lower tax bill because you can deduct it even if you don’t itemize. The recipient must report the alimony as income, thereby increasing his or her tax bill. What’s more, you most definitely need a written separation or divorce decree stating that alimony payments are not child support. No written order means no tax break.
Couples who are facing extended divorce proceedings due to finances, custody battles or state laws need to be sure that support during long periods of separation is clearly defined. Even if you pay the bills for your spouse’s home while separated, you cannot deduct that amount as alimony without a written agreement in place.
The Tax Cuts and Jobs Act of 2017 changes the alimony rule. For divorce agreements entered into after December 31, 2018 or existing agreements modified after that date that specifically include this amendment in the modification, alimony is no longer deductible by the payer and is not income to the recipient.
Be Aware of Community Property Rules
If you live in a state subject to community property rules (nine states total) and you file separate returns while still technically married (whether as Married Filing Separately or Head of Household), you will be required to report 50 percent of all income generated by community assets during the time you were married. This includes wage income and any income earned off of community property (property that you acquired during your marriage), like rental income, investment income, and so on.
This can have multiple implications, and the most advantageous filing status (joint or separate) can vary largely depending on how long you were married, assets brought into the marriage vs. those acquired while married, income earned by one spouse vs. another, etc. Furthermore, these community property/allocation rules are handled differently in each state that has these statutes, and the interpretation can become somewhat complex.
It’s important to know what income/deduction/credit items should be split 50/50 on the return and which should not – for example, while sole proprietorship income of one spouse is community income that should be split, the self-employment tax on that income is imposed solely on the spouse carrying on the business.
Because of these complexities, it is important to understanding the rules of your state and receive the professional guidance you need in navigating these rules.