Michael Goldman & Associates, L.L.C. - Consulting
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Goldman's
Critical Support -- Winter 2002
Divorce
can drastically change a person’s financial and tax status. How each spouse's
situation changes depends to a large degree on the structure of the divorce
decree or settlement. This article will highlight the fundamentals of divorce
taxation and offer some tips on tax planning. Filing
status A
divorcing couple’s filing status for tax purposes is determined as of the last
day of a tax year. If they have started formal divorce proceedings but are not
legally divorced on December 31, they must file as married, but have the option
of filing jointly (usually the smartest option) or separately. If the
couple is legally divorced and living apart before New Year's Eve, they must
file as single or, if either spouse maintains a home for unmarried children, as
"head of household." Each spouse may file under the favorable
head-of-household status if they have children who qualify. In special cases a
married spouse can qualify as “abandoned” and file as head of household. If the
couple is legally divorced but still living together on December 31, the IRS may
require that they file as married. Tax
liability Allocating
tax items in the year of divorce can be tricky. The IRS follows state property
laws. In equitable distribution states such as
Tax carry
forwards, such as unutilized losses, are allocated based on which spouse
generated them. A special planning opportunity exists with S-corporations –
suspended losses may be lost forever if the stock is transferred before it has
positive basis. It may make sense to make a capital contribution to utilize
those losses before the stock transfer occurs. Structuring
alimony and other payments Here are
the two key rules: First, alimony is taxable to the payee and can be deducted
from gross income by the payer. Second, child support and property settlements
are tax neutral -- neither party pays tax and neither gets a deduction. When the
higher-income spouse makes payments to the lower-income spouse -- which is
typical -- it makes sense to structure payments as alimony, because you can
allocate the deduction to the person in the higher tax bracket and allocate the
income to the person in the lower bracket. That maximizes tax benefits and
leaves more overall income for the parties to share. The
spouse making payments is not always in a higher tax bracket, though. The payer
may have a lot of tax-exempt income (such as disability payments), for example.
In that case, structuring payments as child support or property settlements
might make more sense. Tax
code Keep in
mind the tax treatment of alimony, child support, and other payments made
pursuant to a divorce is governed by the tax code, not the divorce agreements or
court orders. According to the tax code:
Some
settlements require or allow the paying spouse to make payments directly to
third parties for the benefit of the other spouse (for medical treatment, life
insurance premiums, or mortgage payments, for example). Such payments can be
treated as alimony as long as they do not benefit the paying spouse or property
owned by the paying spouse. A common
example is where the husband owns the house but the wife lives in it until the
last child graduates from college. In that case, mortgage payments or
improvements that the husband makes cannot be considered alimony because they
benefit the paying spouse's property. Payments
of otherwise non-deductible items, such as personal interest, may be structured
as alimony to improve their tax characteristics. Property
settlements The first
step in dividing property is determining who owns what. Unless they are
structured as alimony, transfers of property within one year of a divorce are
usually tax-free, because the property is considered marital. For
transfers made within six years of a divorce under a divorce decree, the
transferor’s basis (original cost for tax purposes) in the asset carries over
to the recipient. Transfers made more than six years after the end of the
marriage are generally presumed not related to the end of the marriage, although
it is still possible to qualify for favorable marital property treatment. When
negotiating property transfers, always consider the tax basis and potential tax
liability upon sale of assets. Property
settlements can be structured to qualify as alimony regardless of how they are
used or what the divorce decree states (as long as they are not called child
support). The character of transferred property can also be changed (passive to
active, ordinary to capital gain, etc.) when ownership changes. If done
properly, these techniques can significantly reduce the parties’ combined tax
costs. A trap to
avoid is transferring business property to a non-business owner, which can
trigger depreciation recapture. If a
divorcing couple owns a business, the business can be used as a third party in
property transfers to assist in effectuating transfers of basis and minimizing
overall taxes. Be
careful in doing this – there is no clear direction in this area, and the case
law is still evolving. Retirement
plans Qualified
benefit plans receive preferential tax treatment in divorce if their benefits
are assigned by the court in a “qualified domestic relations order” (QDRO).
QDROs can be used for much more than dividing assets – structured properly,
they can assist with tax planning and liquidity generation. QDROs are used to
both obtain a distribution from a qualified plan for the nonparticipating spouse
and to ensure that the spouse receiving the distribution pays the tax on it. The
regulations regarding QDROs are very precise, and failure to follow any aspect
of them can create harsh unintended tax consequences. QDROs
cannot be used to assign benefits under non-qualified plans such as IRAs.
However, IRAs can be divided tax free under a divorce or separation instrument. The
marital home A
homeowner can exclude up to $250,000 of gain on the sale of a home if he or she
owned it and lived in it for at least two of the five years preceding the sale.
Both divorcing spouses may be eligible for this tax treatment, even if they file
independent returns. If the
marital house is going to be sold for a gain of more than $250,000, it probably
makes sense to leave the house in some form of joint ownership to maximize the
use of both parties’ gain exclusion. Remember,
a house must qualify as your residence to gain deductibility of mortgage
interest and property taxes that you pay. Allowing the children of a nonresident
owner to remain in a home can make mortgage interest payments deductible to the
owner, whether or not the former spouse occupies the home.
© Michael Goldman 2002 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser. |
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