Note: This is a quick summary of key tax issues. If you just love taxes, or if you’re willing to invest the time to learn more, you can get deeper in taxes.
The “Third Spouse”
It’s often said that there are really three parties to a divorce: the husband, the wife, and Uncle Sam. In a sense, that’s right. Far too many people negotiate and finalize their divorce without taking proper account of the tax impact of the decisions they’re considering. Here’s a quick summary of some of the issues I see people miss most often:
Capital Gains on Your House
Capital gains was a big issue until recently, but all that’s changed now. The new tax bill that took effect in August of 1997 effectively does away with capital gains tax on the sale of the marital home for the vast majority of homeowners. you can read all about it onCapital Gains Changes. The new tax law defines a principal residence as the home where you’ve lived for any two of the last five years. If you sell your principal residence anytime on or after May 7, 1997, you are allowed to exclude up to $250,000 of the gain from taxable income if you’re single, $500,000 for a married couple. The one risk that’s still real for many taxpayers from capital gains on the sale of a home is the risk that you might wait too long after you move out of the house before your interest in it gets sold.
Here’s the scenario. The house must have been your principal residence for two of the past five years when you sell it. That means, effectively, that the house must be sold within three years after you move out. It’s common these days in divorce for one of the spouses to move out of the house but to continue owning an interest in it for several years. Once you’ve been gone for more than three years, the house is no longer your principal residence. If it’s sold at a gain, you’ll owe tax on it. Even here, however, Congress has offered some help. The new tax law says that if you move out of the house and your spouse has the right to live in it pursuant to a divorce or written separation agreement, your spouse’s residence in the house will be counted as your residence for purposes of calculating the two year residence requirement.
Alimony vs. Child Support
Periodic alimony is included in the taxable income of the recipient, and it’s tax-deductible to the payor. Child support is not included in the taxable income of the recipient, and it’s not tax-deductible to the payor. So all other things being equal, payors want as much of support as possible to be in the form of alimony, and recipients want as much of support as possible to be in the form of child support.
But all other things usually are not equal, in particular the incomes of the payor and the recipient. When the payor’s income is considerably higher than that of the recipient, there may be an advantage to both spouses to paying alimony rather than child support, because the tax advantages of alimony allow the payor to increase the after-tax support level to the recipient.
It’s not unusual in divorce for the higher-income spouse to agree to pay additional incidental expenses of the other spouse for a term of years, sometimes indefinitely. These are things like medical insurance, life insurance on the payor’s life, home mortgage payments, and car payments. In these cases, it’s usually smart to take the time to ensure that the payments for each such expense qualify as alimony.
The same principle applies to the payments that the payor often makes to the recipient in a one-time property settlement in connection with the divorce itself. It’s often better for both spouses if these can be paid in the form of periodic alimony. Again, the payor may need to increase the payments to compensate the recipient for the cost of the taxes, and both spouses can end up with more money to spend.
A caveat is probably in order here: precisely because it’s better for many couples to pay and receive support in the form of taxable alimony, the government has set up a multi-faceted system of restrictions that can be a trap for the unwary taxpayer who gets too greedy in characterizing support as alimony. One set of restrictions tests to make sure alimony is not “front-loaded” – that is, too concentrated in the period immediately after the divorce. The term for this is “excess alimony.”
Another set of restrictions tests to make sure the alimony isn’t reduced or eliminated on a date corresponding to a date when one or more of the children reaches one of several specified ages. There’s even a special test – I call it the “weird and wonderful” test – to make sure the alimony isn’t reduced or eliminated on two separate dates corresponding to a given age for two or more children. The term for this is “alimony fixed as child support.”
For more information on how alimony works, you can get deeper in taxes.
Exemptions for the Children
Nearly all divorcing couples are aware of the exemptions for the children, and it’s typical for each spouse to believe that he or she is entitled to them. The IRS assumes that the spouse who has custody of the children is entitled to the exemptions, but the spouses are allowed to trade them back and forth freely, using IRS Form 8332. With the passage of the Tax Reform Act of 1997, the exemption now carries with it the right to use the child credit for each child, as well as to use the Hope Scholarship and the Lifetime Learning Credit. You can check out the separate page on Exemptions for the Children to see the value of the exemption for each child at different income levels.
When there are multiple children, one option parents often use — usually the wrong one — is for the spouses to split the exemptions. This may feel fair to both spouses, but the spouses are never better off to share the exemptions, and if one spouse’s income is substantially higher than the other’s, the spouses will be worse off, because they will have missed a chance to maximize tax savings.
The better approach with exemptions is to consult an expert on tax in divorce who can calculate the value of the exemption(s) to each spouse. The one who can make better use of the exemption(s) should take all of them, and if appropriate, compensate the other spouse.
Child Care Credit
The parent who has custody of the children is entitled to claim a credit of from 20% to 30% of the cost of work-related child care, up to a maximum of $960 for two or more children under the age of 13. Unlike the exemption, the child care credit can’t be traded; it’s available only to the custodial parent. The fact that the custodial parent has assigned one or more exemptions using IRS Form 8332 has no effect on the ability to claim the credit for child care expenses.
Filing Status
Your marital status for tax filing is set as of the last day of the year. It depends on your marital status and your family status as of December 31. If you are divorced as of December 31, you must file as single taxpayers for that year, even if you and your spouse lived together as a married couple more than half the year.
If you are still married as of December 31, here’s how it works:
- If you and your spouse lived in the same household and were not legally separated, you must file as married (either a joint return or separate returns).
- You may be able to file as Head of Household even if you were legally married on December 31 (see below).
To file as Head of Household, you must meet all these tests:
- You were unmarried or considered unmarried on December 31.
- You paid more than half the cost of keeping up a home for the year.
- A child or other qualifying person lived with you in the home for more than half the year for whom you or the other parent is entitled to claim the tax exemption.
On average (and there certainly are exceptions), the tax rates get higher in the following order (meaning I’ve listed the most advantageous rate first):
- Married filing jointly
- Single Head of household
- Single
- Married filing separately
Timing of the Divorce
Because the marital status of the parties for purposes of their tax return is set as of the last day of the fiscal year, a couple contemplating divorce near the end of the year should consider whether they would be better off making their divorce effective before the end of the year – allowing them to file as single taxpayers, or making their divorce effective after the end of the year – allowing them to file a joint return.
One caution about filing jointly. The less financially savvy spouse needs to understand that signing a joint return with his or her spouse exposes him or her to liability, even if he or she is not privy to all the calculations included in the return. There is a principle called the “innocent spouse” rule that allows a spouse to escape liability in a few cases. It is narrowly drawn, however, and should never form the basis for planning. Because trust is often at a low ebb as divorcing couples are preparing their final joint return, the less financially savvy spouse may decide to hire an independent accountant to review the return and its supporting documents before he or she signs it.
Other Sites on Taxes
- Internal Revenue Service. Strange but true. It’s a well-designed resource and continuously updated. Useful.
- Taxes 101: 5 Basic Ideas. Kind of elementary, but a good introduction to the key concepts.