What Tax Liabilities Should Be Considered in Divorce?

by Michael Keenan
Dividing property during a divorce has tax implications.

Dividing property during a divorce has tax implications.

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During a divorce, tax law often takes a back seat to issues of distributing martial property and child custody. However, tax implications can turn a seemingly good settlement into a nightmare for an unsuspecting divorcee. Knowing some of the tax implications of divorce ahead of time can help you be prepared for negotiating a settlement.

Alimony and Child Support

Alimony refers to payments made by one ex-spouse to the other, under a divorce decree. These payments can be deducted by the paying spouse and must be included in taxable income by the receiving spouse. For example, if the wife pays the husband $10,000 in alimony per year, the wife could claim a $10,000 income tax deduction, while the husband must include an extra $10,000 in his taxable income. Child support payments cannot be deducted from a taxpayer's income for the year, even though that taxpayer may be legally obligated to make those payments to the ex-spouse. Consequently, the receiving spouse does not include those payments as taxable income.

Retirement Accounts

A divorce decree will often include a qualified domestic relations order, also known as a QDRO, that grants a spouse a portion of the other spouse's retirement plan, such as 401(k) plan. When a distribution is taken before age 59 1/2 to satisfy a QDRO, the spouse receiving the money owes the resulting income taxes but does not have to pay the 10 percent additional tax penalty on early distributions. The receiving spouse also has the option to roll the money into his own retirement plan and defer taxes until he takes distributions. However, if he does so, he no longer qualifies for the exemption from the 10 percent additional tax under the QDRO if he later takes an early distribution.

Basis for Properties

Though two properties might have the same fair market value, the tax liability resulting from the sale of the properties may be significantly different due to the difference of the sales price over the basis. The basis is generally the price paid for the property. Distribution of marital property during a divorce is treated as a gift for tax purposes, which means the basis remains the same. For example, assume a divorcing couple has two homes, both worth $300,000, but they spen $100,000 on house A and $250,000 on house B. If the spouse who gets house A sells it, that spouse must pay taxes on $200,000 of gain ($300,000 - $100,000). However, if the spouse who gets house B sells it, that spouse only has to recognize $50,000 of gain because of the higher basis.

Claiming Dependents

If a divorcing couple has children, they should consider which spouse will claim the children as dependents in future tax years. If the divorcing couple does not reach an agreement, the IRS has specific rules that determine which parent can claim the child -- typically, the parent with whom the child spent the most time during the year. When parents split time evenly, the parent with the higher adjusted gross income can claim the dependent. However, these rules aren't always the most advantages from a tax planning perspective. For example, if the husband falls into a higher income tax bracket, but the wife has the children for more than half the year, the wife would claim the children even though there would be a greater overall tax savings -- that the couple could, perhaps, split between them -- if the husband claimed the deduction.