Legacy Law Blog

Pat Benatar had it right when she described love as a battlefield. When couples marry, they do so with the intention of staying together forever.

Unfortunately, this is not the case for many couples, which end up filing for divorce. During the divorce process, the tax implications of the divorce settlement are frequently overlooked or misunderstood.

When negotiating a divorce settlement, it’s crucial for both spouses to understand how their decisions can affect their tax liabilities—both immediately and in the years to come. It is easy to get overly focused on the division of assets, support and child custody while underestimating the impact of taxes.

With that in mind, here are the key tax considerations divorcing spouses should keep in mind during and after divorce:

Tax Filing Status and Timing

• Your marital status on Dec. 31 during the year you were divorced determines your filing status for that tax year. If your divorce is finalized by the last day of the year, you must file as single (or head of household if you qualify). Otherwise, you can elect to file jointly or separately as married.
• Filing jointly often provides tax benefits, but it also means both spouses are jointly liable for any tax due. Consider the risks, especially if your spouse has complex finances or potential undisclosed income.

Alimony and Child Support

• For divorces finalized after 2018, alimony payments are not deductible by the payer and not taxable to the recipient. For divorces finalized before 2019, alimony payments are generally deductible for the paying spouse with certain exceptions.
• Child support is never deductible by the payer and is not taxable to the recipient.
• If a paying spouse makes a lump sum payment for both alimony and child support and the payer pays less than required, payments are applied to child support first.

Property Division and Asset Transfers

• Transfers of property between spouses as part of a divorce settlement are generally not taxable if they occur “incident to divorce”—typically within one year of the divorce or as specified in the divorce decree.
• After the divorce, if property is sold, capital gains taxes may apply. Each spouse may exclude up to $250,000 of gain from the sale of a primary residence, but only if they meet the ownership and use requirements. If the home is sold while still married, the exclusion can be up to $500,000.
• When dividing assets, consider the after-tax value of each asset. For example, retirement accounts, stocks and real estate may have very different tax consequences when liquidated. It is advisable to consult with an accounting professional when determining how the after-tax value will impact the division of assets to avoid costly mistakes.

Retirement Accounts

• Dividing IRAs and qualified plans like 401(k)s requires careful handling to avoid taxes and penalties. Use a Qualified Domestic Relations Order (QDRO) for 401(k)s and direct transfers for IRAs.
• Withdrawals after transfer may be subject to taxes and penalties if not handled correctly.

Lump-Sum Payments

• Lump-sum payments made to equalize property division are generally not taxable. However, the nature of the payment (alimony vs. property settlement) and the type of asset involved can affect tax treatment.

Dependency Exemptions and Tax Credits

• Generally, the custodial parent (where the child spends more nights) claims the child for tax purposes, including credits like the Child Tax Credit.
• Parents can agree to alternate years or allocate credits, but the custodial parent must complete IRS Form 8332 to allow the noncustodial parent to claim certain credits.

Joint Tax Liabilities and Past Returns

• Both spouses are typically responsible for tax liabilities incurred during the marriage, even if only one spouse earned the income or filed the return.
• It’s important to review past tax returns, address any outstanding liabilities and determine how future audits or refunds will be handled in the settlement.

State and Local Tax Considerations

• State laws can impact the division of property, treatment of support payments and tax consequences. Consult a local expert to ensure compliance with both federal and state tax codes.

Allocation of Marital Tax Liabilities

• If the couple filed their taxes during the marriage as “married filing jointly” and incurred a tax liability for one or more years, the IRS will view the liability as attributable to both spouses.
• Since each spouse is jointly and severally liable for the tax liability, it cannot be designated to a single spouse as part of a divorce settlement. The IRS will not honor any attempt to make one party liable and excuse one party from liability.
• Regardless of the terms of the settlement, the IRS will seek to collect the tax balance from both spouses and then leave the spouses to sue one another to enforce their rights under the settlement.
• Because the IRS will hold both spouses liable for any tax liabilities resulting from “married filing jointly” returns, these liabilities should generally not be assigned to a single spouse in a settlement.

Practical Tips for Navigating a Divorce

• Update your withholding: After divorce, file a new W-4 with your employer to adjust your tax withholding.
• Consult professionals: Work with a tax advisor and an experienced divorce attorney to ensure all tax implications are considered before finalizing the settlement.
• Plan for the future: Consider both the immediate and long-term tax consequences of each settlement option, including the potential for future tax law changes.

Addressing these tax issues early in the negotiation process can help divorcing spouses avoid costly surprises and ensure a fair, financially sound settlement. Because many of the choices made during the settlement can have complicated tax consequences, it is advisable to consult with a tax professional prior to finalizing the divorce.