When spouses are going through a divorce, tax implications may be the least important issue on their minds. But for a fair settlement and most favorable tax impact, people should address these tax considerations and speak with their tax advisor.
Some of the common issues that should be addressed in the marital separation agreement include:
Alimony and child support payments
After the passage of the Tax Cuts and Jobs Act of 2017, alimony and support payments are no longer deductible by the payer and no longer includible as gross income by the receiver (applies to divorce agreements executed after December 31, 2018). The “old rules” still apply to the divorce agreements executed on or before December 31, 2018 (i.e., alimony is taxable to the recipient & deductible by the payer). Note: Child support payments are never deductible by the paying spouse nor includible as income to the receiving spouse irrespective of the date of separation.
Generally, if a married couple sells their personal residence in connection with a divorce or legal separation agreement (provided they have lived in the house for 2 out of 5 preceding years), they can avoid tax on up to $500,000 of gain. If one of the spouses continue living in the house and the other moves out and they both continue to be the owners, then at the time of a future sale they still may be able to avoid tax on gain of up to $250,000 each. For this exclusion, there must be a special language in the divorce agreement that will protect the exclusion for the spouse who is moving out.
A divorce or legal separation under a decree of divorce or separate maintenance is also considered an “unforeseen circumstance” safe harbor, qualifying for a partial gain exclusion from the sale of the family home if the couple failed to maintain it as personal residence for the requisite 2 out of the last 5 years.
Retirement/401(k) assets are often split between spouses in order to equitably divide marital assets. The courts often issue a qualified domestic relations order (QDRO) which gives one spouse the right to share in the pension/retirement account benefits of the other and shifts the tax burden to the spouse that ultimately receives the distributions. Without a QDRO in place, the spouse that earned the benefits will pay taxes on the distribution even though the ex-spouse received the money.
Filing Status on Returns
The filing status for income tax returns is determined by your marital status on December 31st, the last day of the calendar year. If you are legally separated on December 31st, you may be able to file as single/head of household. There are advantages of filing as head of household, but you must fulfill certain requirements to qualify as a head of household (including living apart for 6 months and providing a home for a qualified dependent). Depending on your filing status, you may want to adjust your tax withholdings, accordingly.
Family Asset includes interest in a business
If you own a business, you may have to consider how this asset will be shared at the time of divorce or separation. Depending on the nature of the business, sometimes a valuation (or a calculation of value) of the business whether may be worthwhile to both spouses. In many cases, a company buy-sell agreement may have some bearing on the overall business (buy sell agreements often contemplate a divorce scenario).
Marital Property/Income Considerations
If you live in one of the nine community property states (i.e., Wisconsin), you’ll have to consider income earned before and after the date of divorce. For example, wage income and related income tax withholdings prior to the divorce is generally split 50/50 (regardless of which spouse earned it). After the date of divorce there is no splitting of wages/withholding. Income arising from other marital property (LLCs or S Corps investments) also would be shared 50-50 pre-divorce. For the non-earning spouse, advanced planning for this phantom income and related tax liabilities is crucial to avoid surprises.
Please reach out to your Wegner CPAs’ tax advisor for guidance for marital and divorce tax planning needs.