4 Things You Need to know about Divorce and Taxes
Tax Season. That time of year when Americans struggle with seemingly endless paperwork, overwhelming anxiety, and relentless frustration. If you are contemplating a divorce, if you’re in the middle of a divorce, or if you just finalized your divorce, then beware — tax season poses special challenges for you. When the stakes are so high, and penalties for mistakes so severe, you need to work diligently to avoid tax traps and tax missteps that could really cause you problems. Lots of people have gotten through this, and you will to. You can avoid expensive tax problems later by paying close attention to these four important concepts involving divorce and taxes.
1. Understand the tax distinction between spousal support and child support
Couples frequently misunderstand the tax consequences, regarding spousal support and child support, on the paying spouse and the receiving spouse.
On the one hand, spousal support (alimony or spousal maintenance) is paid by one party to the other, for the benefit of the recipient party. Spousal support is tax deductible to the obligor spouse, the one who pays. The spousal support is taxable income for the obligee spouse, the one who receives the money.
On the other hand, child support is typically paid by the noncustodial parent to the custodial parent, for the benefit of the child. Child support is not tax deductible for the obligor parent, and is not taxable income to the recipient parent.
2. Understand the tax consequences of dividing property
Under the Internal Revenue Code’s § 1041, the division of property by divorce is not a taxable event. But there is a potential tax issue that is often hidden — the tax basis. The tax basis of a particular property is the price used to determine the capital gains tax when the property is sold (this is usually the purchase price). Some property, as with cash, carries no capital gain when sold. Other property, as with a residence, is exempt from capital gain up to a specified dollar amount. Many investments will incur a capital gains tax when the property is sold.
3. Know your filing status
If you’ve ever had a conversation with the IRS, then you remember this question: “What is your filing status?” Well, if you’re contemplating divorce, in a divorce, or finished with a divorce, your answer to this question has significant tax consequences.
Taxpayers have three options to choose from: single status, married status, and head of household status. The different tax statuses, and the choice of whether or not to file jointly or separately from your spouse if the divorce is not final, will result in significantly different tax liabilities.
The only real way to know exactly how much you would pay or save under the three statuses is to calculate your taxes under each alternative (and speak with your tax advisor). If you are using Turbo Tax, or similar tax preparation software, then you can easily calculate all three tax results, and then file the one that saves you the most money. Preparing multiple drafts of your taxes to calculate your potential tax liability is an investment of time, but it could easily save you hundreds or even thousands of tax dollars.
4. Understand your attorney’s fees are probably not tax deductible
Most of the professional fees paid to your divorce attorney will not be tax deductible. With one very small exception: § 212 of the Internal Revenue Code. Under this section, professional fees paid to your divorce attorney in the production or collection of gross income are tax deductible. It is unlikely that all or even most of the attorney’s fees you’ve paid will qualify for the § 212 exception, but discuss it with your attorney (and tax advisor). He or she will ensure that you’re aware of and receive credit for every tax-deductible dollar.