Key - Personal

Avoiding the Tax Traps

Like any major financial transaction, divorce has serious tax implications. And pitfalls galore for unwary individuals. Don't expect much help from your divorce attorney. These folks are often surprisingly ignorant about taxes (and disinclined to admit it). So it's up to you to become educated on the subject before you reach any final agreements with your soon-to-be ex. Once the papers have been signed, few problems can be corrected.

Dividing Things Up

Generally, splitting up ownership of your assets has no immediate federal tax consequences. You are allowed to make tax-free transfers of houses, cars, other real and personal property, investments held in taxable investment accounts, business-ownership interests and so forth while still married or as part of your property-settlement agreement.

Nevertheless, taxes are still an important issue because whoever winds up owing appreciated assets (for example, stock or a valuable baseball-card collection) will eventually owe taxes when the assets are sold. So if your ex ends up with 50% of everything in the form of cash and you end up with 50% in the form of appreciated assets, guess who actually got the short end of the stick? This won't happen if you use our Property Settlement Calculator to analyze the after-tax results of proposed property settlements. Don't sign your divorce papers without doing this first.

If your ex will receive a share of your retirement-account money, watch out! Without some planning, you could get stuck paying taxes on your spouse's share.

As for your home, (or homes), planning is needed to take full advantage of the favorable rule allowing tax-free home-sale profits of up to $500,000 for a married couple and $250,000 for singles. You want to make sure this valuable tax benefit doesn't get lost in the shuffle.

Joint vs. Separate Returns

Another major issue for separated and recently divorced individuals is whether to file joint or separate tax returns. Your marital standing at year-end determines your filing status for the entire year. So if you are still married at the end of this year, your choice is to file jointly with your soon-to-be ex or use married filing separate (MFS) status. Unfortunately, MFS filers get treated very unfavorably under the tax rules. So there may be an incentive to file jointly despite your upcoming split. You might also qualify for head of household (HOH) filing status while still married. If so, this is much better than MFS.

Depending on how long it takes to finalize the divorce, these tax-filing options may be open for several years. However, if you are legally separated under a decree of separate maintenance at the end of the year, you are considered divorced for federal income tax purposes and therefore single for that year. Note that this tax-law definition of "legally separated" is not the same as being "separated" in the common sense of the term (i.e, living in separate residences).

The big advantage of filing a separate return — whether it be MFS or HOH — is the IRS won't hold you responsible for any unpaid taxes caused by your then-spouse's actions or omissions. In contrast, when you file jointly, the IRS can go after you for 100% of any tax shortfall on the joint return. This can happen if, for example, your then-spouse failed to report income, overstated deductions or skipped required tax payments. You are at high risk if the other party operated a business or made lots of investment transactions. Thanks to a 1998 law change, you may be able to wriggle off the hook for unpaid joint return taxes by claiming you were an "innocent spouse." Then you're held responsible only for tax underpayments caused by your own actions or from stuff your then-spouse did that you actually knew about. If you have any doubts in this regard, you are well-advised to simply avoid the entire issue by filing a separate return.

Now let's put the shoe on the other foot. If you earn most or all of the income, you will almost certainly face a bigger tax bill if you have to file HOH or MFS instead of jointly. It helps no one if more of your money goes to the government, so it's understandable if you want to lobby to file a joint return. Just don't be surprised if the other side raises the concerns we just covered and demands some financial concessions for agreeing to sign a joint return.

Alimony, Child Support and The Kids

Taxwise, there's a huge distinction between alimony payments and child support. Child-support payments are tax-free money for the ex-spouse who receives them and a nondeductible expense for the person who writes the checks. In contrast, the recipient of alimony payments has taxable income while the payer gets a deduction.

That seems simple enough, but it's actually quite a challenge to structure payments that qualify as deductible alimony under the tax guidelines. Payments that don't pass all the tests will generally be considered child support or part of your property settlement. You get no deduction for either.

If you have children, you will also need to negotiate who gets the dependent exemptions for the kids. Generally, it's the parent that the children live with. However, parents can agree to override this general rule and allocate the exemptions in any manner they can agree upon.

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