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TAX CONSIDERATIONS IN CONNECTION WITH DIVORCE AND SEPARATION

Updated as of February 2001

This outline sets forth many but not all of the very complex rules that apply to divorcing couples. It is intended for application in Texas, a community property state.


Filing Status
Filing status - whether an individual is considered married or unmarried is determined on last day of the tax year.

Considered unmarried for the entire year if by December 31 you have obtained a final decree of divorce.

Decree of annulment - considered unmarried for entire period and all prior tax returns filed for years where the statute of limitations is open (normally 3 years) should be amended to reflect an unmarried status.

Head of household - available to unmarried individuals with dependents living at home and certain married individuals:

Advantages:
1. Standard deduction is higher than single or married filing separately.

2. Tax rate tables are more favorable than single or married filing separately.

3. Certain credits may be claimed that are not available if married filing separately.

4. Limits on itemized deductions and phase-out of exemptions occur at much higher income levels than single or married filing separately.

Requirements:
1. You must have paid more than one half the cost of maintaining your household for more than one half of the year for yourself and a qualifying individual.

Qualifying individuals include:

a. Your unmarried child, grandchild, foster child or adopted child. Except for a foster child, the child does not have to be a dependent.

b. Your married child, grandchild, foster child or adopted child you claim as a dependent or could have been claimed had you not relinquished the exemption to the other spouse.

c. Any other relative that qualifies as a dependent, for example if father or mother do not live with you but you paid more than one half of the cost of keeping up their home for the entire year.

Considered unmarried and qualify as Head of Household if you meet all of the following tests:

a. Do not file a joint return.

b. Paid more than one half the cost of keeping up your home during the last 6 months of the year.

c. Spouse did not live with you the last 6 months.

d. Your home was the main home of your dependent for more than one half the year.

Married filing separately - main advantage is that it insures separate liability for the income reported on your return and does not expose you to your spouse's liability.

Essentially divides the married filing jointly tax tables in half. With community property rules requiring each spouse to account for his/her share of community income, no real tax advantage to filing separately except for the avoidance of liability for spouse's income.

You should always consider filing separately if you suspect your spouse might be cheating on taxes by omitted income, inflated or falsified deductions or through other means.

You should also consider filing separately if payment of tax by you or your spouse will be a concern. By filing separately, you will limit your exposure to the unpaid taxes, interest and penalties.

Since a joint refund may be applied against certain debts of your spouse including unpaid child support and unpaid student loans, you should consider filing separately. You should also consider filing separately if this applies to you.

Effects of filing a separate return:

  • Separate liability for tax.
  • If your spouse itemizes deductions so must you.
  • Cannot take the credit for child and dependent care.
  • Cannot claim the earned income credit.
  • Cannot take education credits and deduct student loan interest.
  • Cannot roll over amounts from traditional IRA to a Roth IRA.


Changing Filing Status
Once an election is made to file a joint return, it cannot be changed after the due date of the return. A separate return may be changed to a joint return by filing an amended return any time up until the statute of limitations (normally 3 years) expires for the year in question.

Alert! A joint return election is not considered valid unless both spouses sign the return. However, a Court has held where a spouse held out for additional remuneration for filing jointly that since a pattern of filing joint returns had been established, a joint extension request was filed, and the non signing spouse did not file a separate return, a valid joint return election was made with the signature of one spouse.


Exemptions
Exemptions for dependents:
Neither spouse may claim the other spouse as a dependent on a separate return.

A dependent must be a member of your household unless the exemption is awarded to the non-custodial parent by the divorce decree or by written waiver from the custodial spouse.

  • Waiver may be a blanket waiver or year by year election
  • Waiver is made by signing Form 8332 (or similar statement). Non-custodial parent attaches the waiver to his/her income tax return.

Child support is deemed to be used for support of the children even if not used for support.

Determination of custodial parent is determined by reference to the parent awarded the greatest period of physical custody by terms of the divorce decree or separation instrument. If the decree does not establish custody or awards "split custody", then the parent having actual custody for most of the year will be entitled to the exemption.

Alert! In order to claim an exemption for dependents on a married filing separately return, a taxpayer must provide more than one half the support for the child. In Texas, a community property state, the IRS has ruled that if the children are supported from community funds during a year that the spouses lived together, then neither spouse is deemed to have provided more than one half the support and the exemption for these dependents is available to neither spouse!!!

Alert! IRS now matches the name and social security number of dependents listed. Make sure to list the child's legal name on the return as reflected with the Social Security Administration ("SSA"). Failure to correctly match will result in routine disallowance of dependency exemption.

Any name changes of the child or parent should be promptly reported to the SSA.

Medical expenses - a child of divorced parents is deemed to be a dependent of each for purposes of each spouse claiming his/her respective share of medical expenses.


Relief from Joint and Several Liability
There are three types of relief from joint liability:

1) Innocent spouse relief applicable to all joint filers.

2) Election to allocate deficiency which applies to joint filers who are divorced, legally separated, or widowed, or have not lived together for the past 12 months.

3) Equitable relief, which applies to both joint and separate returns in community property states.

Alert! A divorce instrument making one spouse liable for all of the taxes on income through the date of divorce is not binding on the IRS. The IRS often seeks the fastest method of recovery of unpaid taxes without regard to the interests of the individuals.

The primary exception to joint and several liability when filing joint returns is the Innocent Spouse rule. An Innocent Spouse is excused from joint and several liability where there exists a "understatement" of tax attributable to "erroneous items" of the other spouse.

Innocent spouse must show that he or she did not know nor had no reason to know of the grossly erroneous item.

Additionally, taking into account all the facts and circumstances it would be unfair to hold innocent spouse liable for the tax liability. If a person received a benefit from the understatement, he or she may fail the test.

Separation of liability - an allocation of an understatement of tax will be made where a spouse requests such treatment by filing Form 8857 and is either no longer married to, or are legally separated from the spouse with which a joint return was filed and you are requesting relief or you were not a member of the same household at any time during the 12 month period ending on the date Form 8857 is filed.

Community property rules will be ignored such that salary, wages, business and investment income are allocated to the spouse who owned or earned the income.

Separation of liability and equitable relief apply to deficiencies arising or outstanding after July 22, 1998. Form 8857 must be filed no later than 2 years after the date on which the IRS initiated collection activities against you after July 22, 1998.


Dependent Care Credit
A dependent care credit up to 30% of qualified expenses is available for the custodial parent. The 30% credit is reduced by 1% for each $2,000 that the parent's adjusted gross income exceeds $10,000, but not below 20%.

The credit is available for children under age 13. The maximum amount of expenses that may be taken into account is $2,400 for one child and $4,800 for two or more children. These amounts must be reduced by any amount excluded from income under an employer sponsored cafeteria plan. The amount taken into account cannot exceed the taxpayer's earned income (or the taxpayer's spouse, if less) for the year. Earnings are determined without regard to community property rules.

Alert! The non-custodial spouse will never be entitled to a dependent care credit even if awarded the exemption.

Child credit
The parent entitled to the dependency exemption will also be eligible for the Child Tax Credit. The credit is $500 per qualifying child.

A qualifying child is generally a child under age 17 at the end of the calendar year for which a dependency exemption is allowed.

The amount of credit is phased out by $50 for each $1,000 of modified adjusted gross income exceeding a threshold amount. The threshold amounts are:

  • Married filing joint $110,000
  • Unmarried or Head of Household $75,000
  • Married filing separately $55,000


Education and Hope Scholarship Credits
The Hope Scholarship Credit is a nonrefundable tax credit up to $1,500 per student of qualified tuition and related expenses paid by the taxpayer for the first two years of post-secondary degree at an eligible institution.

The Lifetime Learning Credit is an amount equal to 20% of up to $5,000 ($10,000 for years after 2002) of qualified tuition and related expenses paid by the taxpayer for all education at an eligible institution, including post graduate work.

The qualified tuition and related expenses paid to an eligible institution generally include tuition and fees for the taxpayer, spouse, and any dependent of the taxpayer with respect to whom the taxpayer is allowed an exemption. Qualified expenses generally do not include books, lodging, student activity fees, and athletic fees.

Both the Hope and Lifetime Learning Credit are phased out for taxpayers with modified adjusted gross income over $40,000 ($80,000 for joint returns).


Alimony
Contractual alimony is a good way for the payments between the spouses to be subsidized by Uncle Sam. The economics are that the benefits of the alimony deduction to the higher bracket spouse are worth more than the tax cost to the lower bracket spouse.

Payer spouse gets a deduction when alimony is paid.

Recipient spouse includes alimony in gross income (note alimony income is considered earned income for purposes of qualifying for a traditional or Roth IRA).

Alimony must be pursuant to a Divorce or Separation instrument.

Not required to itemize deductions for purposes of claiming alimony deduction.

You must report the recipient spouse's social security number or be penalized.

The following payments do not qualify as alimony:
Child support payments

Non-cash property settlements

Payments that are your spouse's share of community income

Payments to keep up the payer's property e.g. paying the expenses of your separate property home that your spouse lives in will not qualify as alimony.

Requirements for payments to qualify as alimony:
Payments must be in cash.

Payments cannot be "front loaded".

Must by its explicit terms terminate at the death of the payee spouse.

Payer and payee spouse must not file a joint return.

Payment of life insurance premiums on a policy owned by the payee spouse is alimony if made pursuant to a divorce decree.

Payments that are a fixed percentage of income can qualify as alimony.

Payments that terminate on a contingency related to a child will not qualify as alimony.

Underpayments - if payer spouse is delinquent on child support payments, alimony payments will be first applied to unpaid child support before qualifying as alimony.

If the Divorce Decree states that one spouse must make the payments on jointly owned property then the payer spouse may be entitled to an alimony deduction for one half of the payments (including insurance, repairs, etc.) and also deduct the other half as mortgage interest and real estate taxes. Recipient spouse will report alimony income for one half of the payments.

Alert! A voluntary payment to a former spouse could result in a taxable gift if it is not required under the Divorce instrument. Generally amounts in excess of $10,000 could be considered taxable gifts.


Sale of a Principal Residence
Sales occurring after May 6, 1997 have new rules with respect to the treatment of gains on the sale of a principal residence. Losses continue to be non-deductible.

- Prior rules permitted the rollover of the gain on the sale of a residence to the extent the proceeds were used to purchase a replacement residence; taxpayers over age 54 were permitted a once in a lifetime exclusion of $125,000.

- New rules for sales occurring after May 6, 1997 provide for no-recognition of gain to the extent of $500,000 for a married couple and $250,000 for a single person. Exclusion may be applied once every two years.
Most sales will not require reporting on Form 1040.

- Two year requirement: critical test is that the property be owned and used in two of the previous five years as the principal residence of the seller.

- Special rule for divorcing couples — each spouse must meet the use and ownership test separately if a joint return is not filed. The use by a spouse or former spouse may be imputed to the other spouse for the period a divorce instrument grants the use of the home to the spouse who occupies the home. A spouse's sole use of the marital home prior to the entry of a divorce instrument is not imputed to the other spouse.

- Special Hardship Relief: the two-year rule is relaxed and the exclusion ($500,000/$250,000) is prorated over the period of use/ownership in the case of a homeowner forced to sell due to a hardship. Hardship includes a job transfer, illness, or other unforeseen hardship yet to be defined by the IRS.

For sales of residence not qualifying for or in excess of exclusion amounts, preferential capital gains treatment (20% maximum tax rate) may apply if held for at least one year.

Other Property Transfers
No gain or loss is recognized on property transfers between spouses if the transfer is to a spouse or a former spouse and the transfer is incident to a divorce. The transferee spouse obtains the same tax basis and holding as the transferor of the property.

A transfer is "incident to a divorce" if either transfer occurs not more than one year after the date on which the marriage ceases, or the transfer is related to the cessation of the marriage.

Regulations hold that transfers pursuant to a divorce instrument and not more than 6 years after the cessation of the marriage will qualify.

Alert! Property that is sold after marriage with the proceeds split between the parties will result in income or gain to the record title owner. In other words, the structure of the transaction will dictate the tax consequences rather than the economics.

Unlike normal gifts a built in loss may be transferred between spouses when basis of the property exceeds the fair market value.

Alert! Watch out for transfers of property having phantom income potential.

A passive loss carryover associated with the property will be added to the tax basis when the related property is transferred between spouses incident to a divorce.

An interest bearing installment note given as part of the property settlement will result in interest income to the recipient spouse and possibly deductible interest (vs. nondeductible personal interest) if the debt can qualify as mortgage interest, investment interest, or business interest.

Alert! An asset representing the right to receive income such as a trade accounts receivable will not result in shifting the income tax burden to the payee spouse.


QDRO'S and IRA's
QDRO- Qualified Domestic Relations Order is an order of the Court to a qualified plan directing the division of benefits to an alternate payee spouse or child.

Payments from the plan pursuant to the QDRO are taxed to the recipient spouse but are excepted from the 10% premature withdrawal penalty (before age 59 ½).

Payments from the plan representing child support pursuant to the QDRO are taxed to the spouse covered by the plan.

Lump sum distributions from a qualified plan may be rolled over into an IRA of the recipient spouse.

Alert! Care should be exercised in that the divorce instrument must incorporate by specific reference to the assignment of an IRA to a former spouse. Note that a distribution from a spouse's IRA cannot be rolled over into the assignee spouse's IRA. The transfer should be made by persons exercising due care by the custodian. A mistake by the custodian will not be an excusable exception to the tax consequences that may occur due to an inadvertent distribution.


Early Distributions from IRA's to Buy New Home
The 10% penalty for early withdrawal (before age 59 ½), is waived for a "qualified first time homebuyer distribution":

  • Any distribution that is used within 120 days after it was received to pay the qualified acquisition costs of a principal residence of a first time homebuyer.
  • Distributions up to $10,000 qualify.
  • First time homebuyer is an individual who has had no present ownership interest in a two year period ending on the date of acquisition.
  • May include an individual, his/her spouse, child, grandchild, or ancestor of the individual or his/her spouse.
  • Date of acquisition is the date a binding contract is executed.


Tax Treatment of Costs of Getting Divorce
Generally the costs of getting a divorce are nondeductible. Divorce related costs that are allocable to collection of income including alimony and tax advice may be deductible as a miscellaneous itemized deduction subject to a floor of 2% of adjusted gross income.

Treatment of Community Income
Normally community income earned during the marriage must be allocated according to community property rules unless all of the following apply:

  • spouses are married at any time during the year
  • live apart at all times during the year
  • do not file a joint tax return
  • one or both have earned income which is community income, and
  • no part of the earned income is transferred between them during the year. Transfers for support of the children are not considered transfers of community income for this purpose.

A further exception provides that the IRS may disregard community property rules where a spouse having income acts as if he or she is solely entitled to such income and fails to notify the other spouse of the nature and amount of the income before the due date of the return for which the item is reportable.

Alert! This exception is at the election of the IRS!

Another exception to the community property rules where all of the following apply:

  • Spouses do not file a joint return
  • Income item omitted from the gross income of the spouse is earned income of the other spouse or income attributable to the other spouse's separate property
  • The spouse seeking relief did not know or establishes that he or she had no reason to know of such item of community income, and
  • Under the facts and circumstances it is inequitable to include such item in the income of the spouse seeking relief

Whether the spouse knew or had reason to know is a facts and circumstances test. Merely not knowing the amount of income is not sufficient according to the Courts.