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Tax Tips in Divorce Litigation


Before reading this article understand that I, Eric Roy, am not a certified public accountant. I am a lawyer. Thus, please don't entirely rely on the information supplied here. For a better understanding of tax consequences in divorce as well as tax avoidance techniques be sure to speak to a certified public accountant.

Tax considerations should be taken into consideration at several different levels within settlement negotiation and/or litigation of a divorce. There will be times when it will be in your best interest to keep your knowledge of tax consequences private as you negotiate a global settlement of all issues. There will be other times when it may be in your best interest to confer with opposing counsel or the opposing party so as to work as a team to limit overall tax liability stemming from the divorce process.

The first principle to keep in mind is that property transfers between spouses are in and of themselves non-taxable events. The IRS treats these transfers as gifts even if these "gifts" are incident to a divorce proceeding. That being said, keep in mind that when there is a property transfer incident to divorce that the spouse who receives the property takes the property with the original basis in that property. Thus this recipient spouse will likely be hit with the ultimate tax liability upon ultimate disposition of this same property. For example, if a property is purchased for $100,000 and ten years later it is worth $200,000 then that property has a current value of $200,000. The same parties may also have $200,000 in the bank. Don't assume that these two assets valued at $200,000 respectively are of the same worth. The $200,000 property will be subject to tax on the $100,000 capital gain upon sale. The money in the bank has already been taxed. So keep in mind the distinction between pre-tax and post-tax dollars when negotiating a property settlement.

In most divorce cases you will at least be dealing with a marital residence. This is a home which the parties have purchased during the marriage, which hopefully has some equity in it. Generally speaking when a property is sold the selling party is taxed on the "capital gain". The capital gain being the profit margin on the home above and beyond the expense incurred in purchasing the home initially. By way of example, if a house is purchased in 1995 for $200,000 and sells for $400,000 in 2015 then the parties are left with a capital gain of $200,000. Generally speaking this capital gain is taxable. Fortunately, there is an exception for individuals who sell their "principle residence". The exception applies if the seller uses the proceeds from the house they sell to purchase a new house. When this occurs, the taxable gain is deferred. Thus ultimately the tax consequence will likely be absorbed but there are no immediate tax consequences as there otherwise would be. Of course if the new house is purchased for less money than the amount of the sale of the initial residence then only so much of the sale price as was absorbed into the second residence becomes deferred. Up to $125,000 of this gain can be indefinitely deferred if the individual wishes to utilize a one-time-only lifetime exclusion from capital gains. This one-time exclusion is only available for individuals over age 55, it is essentially a benefit to retirees.

This rollover option, meant to avoid capital gains taxes, comes into play within the divorce proceedings in a couple of ways. One of which is the situation where the married parties have been living separately for a period of time. If the house is ordered to be sold by the parties with the proceeds to be divided between the parties then you will lose one-half of the value of that capital gain deferment. The reason for this is because only the individual who uses the house as a "primary residence" can use the deferment benefit. Thus the spouse who has been living outside of the marital residence for the past year or so will realize the impact of the capital gain tax on his or her share of the proceeds. Given this fact it may make more sense for the individual who has not been the primary resident to transfer his or her interest to the primary resident spouse. This transferring spouse can then seek to obtain an offset either by way of other marital property or alimony.

Keep in mind that alimony is a tax deductible event to the payor spouse and taxable to the recipient spouse. This is useful in the fact that $100,000 in alimony payments is more valuable to a payor spouse than a $100,000 property distribution by the same spouse to the recipient spouse. On the $100,000 alimony payment the payor spouse realizes a significant tax deduction. By the same token the $100,000 property distribution payment is much more valuable to the recipient spouse than $100,000 of alimony would be as on the former the recipient spouse will realize no taxable income while on the alimony payment she or he would be taxed. If the parties work together they can effectuate significant savings given the wide discrepancy in tax brackets these days. If the payor spouse is in a significantly higher tax bracket then the recipient spouse as is often the case then this discrepancy provides that the alimony deduction will be worth more to the payor spouse who can thus as a result afford to pay the recipient spouse more than he or she otherwise would be able to. The recipient spouse is then taxed at a lower rate so when the tax is received by the recipient spouse he or she pays a much lower rate on those dollars.

Remember that in order for the payor spouse to receive this tax deduction then the money paid must qualify as alimony per the IRS code. Thus these payments must be made in cash or cash equivalent payments and these payments must be made pursuant to a court order. Thus voluntary cash payments made from one spouse to another which don't correspond to any court order will not be afforded such tax savings benefit.

Another trick to keep in mind as a practitioner is the use of unallocated payments for support. As we know, alimony is tax deductible to the payor spouse and child support has no tax consequences for the payor spouse or the recipient spouse. Unallocated support payments are treated the same as alimony. Thus if you represent the payor spouse it might not be a bad idea to lump all of your client's support obligations into one support payment as opposed to differentiating between child support and alimony. In this way your client will receive the tax write off for the entirety of this amount as opposed to simply the alimony portion. This is the type of thing that is useful to negotiate with the recipient spouse, perhaps give the recipient spouse the tax credit each and every year despite the joint custody order as a way of promoting a win for both parties.

Of course you need to be careful when structuring child support payments as unallocated support payments. The Internal Revenue Code is privy to this and as such has created provisions to try to catch and stop such actions. The IRS will treat the payments as child support payments if the order provides for a reduction upon the happening of a contingency related to the child reaching majority, death, or specific educational attainment. If the payments are to cease within the six month period before or after the child is to reach the age of majority then they will be deemed to be child support payments. Thus your order must be crafted in a way that doesn't provide for modification upon a contingency related to the child. A good way to get around this is by making adjustments to the terms of payment with regard to length and amount to compensate for what would otherwise be a termination of child support upon the child's reaching an age of majority.

The tax code allows for a dependency exemption for each minor child of the custodial parent. That being said, if the custodial parent wishes to waive this exemption then they can sign a statement confirming that they will not claim the child as a dependent for that year. In this way the non-custodial parent can claim the exemption for that year. This becomes important when the custodial parent has a high income. As the dependency exemption is phased out for high income earners. Thus it may make sense for the parties to see which parent can best benefit from the exemption. Of course if the non-custodial parent is allowed to take the exemption then there will need to be some type of quid pro quo realized by the custodial parent.

Another consideration for the practitioner is whether to advise clients to divorce before or after the end of the year for tax purposes. Taxpayer's filing status dictates what tax rate will be imposed on the parties' income. The marital status of the parties at the end of a given tax year determines the parties federal tax status for filing purposes. Thus if the parties are divorced on the last day of the tax year then they will be deemed to be single taxpayers for filing purposes. Of course, married people are not allowed to file as single, they can only file as married filing jointly or married filing separately. An individual can file as head of household and be taxed at the lowest tax rate if they are divorced before the end of the tax year. Additionally the individual must have provided a home for a dependent for more than half of the year. As you can see, it might make sense for this individual to file for divorce before the end of the year so as to realize the benefit of this lower tax rate.

Often times your clients will want to know whether they should file married filing jointly or married filing separately. Generally the tax benefits of the married filing jointly designation will provide for greater tax savings. That being said, if there is reason for a spouse to want to protect himself or herself from tax liability imposed because of the other spouse's actions then they may want to consider the married filing separately designation. In this way they can in some way deflect the joint and several liability imposed by the married filing jointly designation. If the parties do file jointly, exceptions to the joint and several liability may still be had. Such is the case with the innocent spouse doctrine. However, in reality this doctrine offers very limited protections. In order to avoid liability in this context the taxpayer has to demonstrate that he or she didn't even have reason to know of the grossly erroneous items and as such that it would be unfair to hold the innocent spouse liable. The IRS will look to see if the innocent spouse significantly benefited from the error or omission. Usually they will. Thus it is a high standard to qualify as an innocent spouse.

If your client is has the choice of paying alimony or alternatively paying the same value in terms of a property settlement payment well then of course the alimony payments will be preferable given the tax benefits which accrue to alimony payment but not realized by a property distribution. That being said the Internal Revenue Service is privy to property settlement payments disguised as alimony payments. If you are aware of the test the IRS uses to determine if these are disguised property settlement payments then you can avoid any recapture by the IRS. The IRS will look for "front loading". Front loading is the concept where the "alimony" payments are made in much larger payments during the first year or two of the payments. Thus as counsel you need to extend the payments over a longer period of time and equalize the amount of the payments at least over the first three years of payment. This will avoid recapture, which is when the IRS captures the excess alimony payments paid in the initial years and adds them back onto the payer's taxable income.

A last thought to consider is the treatment of interest on deferred property settlement payments. This interest is taxable to the recipient spouse and cannot be used to write off any income by the payor spouse. Thus it would be a good idea to quantify this amount of interest and label it as "alimony" in your decree and pay it out as such. In this way the tax savings is realized by the payor spouse and the recipient spouse notices no difference as the income is taxable income whether it is classified as interest or alimony.

Categories: Family Law