Back in the distant mists of time, I got a divorce. It was easy. We had no children and no disputes over splitting assets. We sold the house and split the profits, and we even shared an attorney (his best man at the wedding).
However, when you have a lot invested in a marriage—time, children, family connections, assets, businesses, and a lot of anger—a divorce can get very messy. It’s even worse when only one of you is working with a tax professional that understands how to split up assets. That person can make it seem like you’re getting a fair split until you try to sell or cash in the assets. Suddenly, you may find that you’ve been left holding the bag on all the taxes while your ex has all the tax-free assets.
Here are some tax tips to keep in mind during a divorce:
1. Children. Define who gets the dependency exemption for the children. Use Form 8332, which supersedes divorce agreements in the eyes of the IRS, to assign the dependent to the correct parent for each of the next several years. Without this form, you face the tiebreaker rules, which are not really equitable at all.
2. Support. The support that is being provided must be clearly defined. Child support and family support are not taxable to the person receiving the funds nor are they deductible to the person making the payments. When the money is meant to help care for the children and cover their schooling and such, you definitely do not want it to be regarded as alimony because the parent receiving alimony pays tax on that money.
3. Alimony. Alimony is for the support of the former spouse. It must be paid for at least three years, and it cannot continue after death. If it is designed to stop when the children are 18, the IRS might regard it as child support rather than alimony. Most importantly, this is not a big lump sum payment from the sale of joint assets. That’s a split of marital property, and it generates no tax effects.
4. Assets. Some assets, like cash, CDs, and savings accounts, have no impact whatsoever on taxes or raise just minor issues. In many cases, whoever gets these types of assets gets 100 percent of their value.
Other assets, like retirement accounts, regular IRAs, and annuities, are often untaxed from the very beginning. Whoever gets those assets will pay all the tax on the money he or she draws out.
When it comes to splitting assets, problems arise when there are investments like securities or rental properties that have been held for many years. These will have a very low basis (tax cost) but will have appreciated substantially over 10, 20, or 40 years. The person getting those assets will be stuck with all the taxes on the depreciation and capital gains.
You can, however, avoid paying taxes on at least $250,000 worth of profit when you sell your home, provided you have lived in it for at least two years out of the last five before you sell it. When both divorced spouses stay on title until the home is sold, the IRS even offers a way to get the benefit of the full $500,000 personal residence exclusion.
We could go on for many more hours, pointing out other key issues in-depth. The best advice for a couple going through a divorce is to work with a tax professional who can evaluate your financial and tax options with a clear mind so that you will both get a fair deal.
Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy at http://www.cpelink.com/teamtaxmama.