As if the divorce process did not complicate the life of a client enough as it is, an upcoming tax season represents another source of increased client stress and confusion. In conjunction with other articles we have published (please find links below), this article aims to highlight some of the frequently asked questions we encounter surrounding the taxation of various types of income earned during the divorce process as well as the taxation of assets divided within a marital estate. We also aim to highlight how the Tax Cuts and Jobs Act (TCJA) has principally impacted the overall tax equation for divorcing couples.
According to the most recent year of data available from the IRS, approximately 580,000 taxpayers claimed a tax deduction for alimony paid, totaling $12.4 billion. Very suspiciously, this contrasts with only 406,000 taxpayers who actually reported receiving alimony (and thus paying taxes on alimony received). While this curious fact may result in some head-scratching by both law-abiding taxpayers and IRS agents alike, such “lost” taxable income will soon be irrelevant thanks to a historical change to the taxability of alimony resulting from the TCJA, enacted into law in December 2017. To briefly summarize the impact on divorcing couples:
Out with the Old: Alimony payments (sometimes referred to as “spousal support”) are treated as taxable income to the recipient and are tax-deductible to the person paying the support.
In with the New: The tax deduction for payments of alimony has been eliminated. Alimony payments are no longer treated as taxable income to the recipient and are no longer tax-deductible for the person paying the support. This significant change applies to any divorce or separation instrument executed after December 31, 2018.
Let’s take a simple example. Imagine a spouse is paying annual alimony of $100,000. Under the old tax law, the paying spouse was permitted to deduct the $100,000 annual alimony payment, resulting in a tax savings of $35,000 (assuming a tax rate of 35%). The party receiving the $100,000 annual alimony payment, in comparison, would be taxed on the full amount at his/her respective tax rate, say 20%, resulting in $20,000 of taxes. As you can see in this example, the divorcing parties would have collectively saved $15,000 under the old law, yielding the paying spouse a tax break that previously made the payments more affordable. The TCJA has eliminated this tax break.
Of note, various publications have suggested that the IRS is expected to follow a strict interpretation regarding this provision of the TCJA; that is, for alimony to be deductible, a marital settlement agreement must be approved by the court before December 31, 2018 and meet the rules established for alimony payments under the previous tax law.
A lesser known change brought about by the TCJA which affects the year of divorce is the elimination of personal and dependent exemptions (through 2025). As of January 1, 2018, any prior negotiated benefit to which parent, post-divorce, would claim each child as a dependent is largely meaningless, at least at the Federal level. Taxpayers may still have the opportunity to reduce state-level taxes by claiming dependents. While it can be argued that under the TCJA an expanded child tax credit (increased to $2,000 per qualifying child) and doubling of the standard deduction (to $12,000 for single filers and to $24,000 for joint filers) made up for this elimination, it is nonetheless an important change regarding taxation in the year of divorce. For higher income earners post-divorce, it should be noted that the child tax credit is phased out for single filers with adjusted gross income that exceeds $200,000.
Now that we have provided a summary of some of the more significant tax changes that impact divorcing couples, the following section seeks to highlight some of the frequently asked tax questions we encounter from divorcing clients.
FAQ #1: Is the division of marital property a taxable event?
The answer is no, generally speaking. Imagine that it is agreed that John Doe is to keep a business worth $1 million after the divorce. As equalizing compensation, Jane Doe is to keep a bank account after the divorce worth $1 million. But what if the bank account was originally held in John’s name only? The $1 million bank account now transferred into Jane’s name is not an event that triggers taxes to be paid by Jane.
FAQ #2: What is the tax treatment of receiving appreciated property?
Continuing with the above example, if Jane instead received a standard (or non-qualified) investment account worth $1 million, is the $1 million taxable to Jane? The answer is not yet. Upon receipt or assignment of the account, Jane is not taxed as though she has “made” or “earned” $1 million. However, because the account likely contains investments that have appreciated in value, when Jane sells the appreciated investments, a taxable event may occur since the original basis will carry over. In the case of receiving a traditional 401(k) account worth $1 million, Jane will be taxed once she begins withdrawals from the account (standard 401(k) tax rules apply here).
Retirement accounts can become key tools to be used during settlement negotiations of a divorce. Be sure to understand which divided accounts contain a total value that represents pre-tax assets.
FAQ #3: If I am to receive the marital home or a vacation property at its current value, shouldn’t realtor fees be considered?
The answer is likely no, but it does depend on a case-by-case basis. For example, when a spouse is to receive a marital home appraised for $500,000 as part of a proposed divorce settlement, that spouse is often unable to argue that they are only really receiving an asset worth $470,000 ($500,000 less 6% realtor fees). This is most notably the case when the spouse receiving the real estate has no real intention to sell the property. As a reminder, this is not a black-and-white rule and may vary state by state. The consideration of potential realtor fees may be considered as part of a broader settlement negotiation, and as such, clients should discuss this concept in detail with their attorney.
FAQ #4: I am currently receiving alimony from a pre-2019 settlement agreement, with the new tax law in place, can I cease reporting it as taxable income?
Unfortunately, the answer is no. The old rules for reporting alimony as taxable income remain in place for those agreements entered into before December 31, 2018.
FAQ #5: My spouse makes considerable estimated tax payments throughout the year, if this results in a refund next year, who gets the money?
The answer is it depends. Hopefully, this situation is identified and properly addressed by both the attorney and financial expert(s) during the divorce proceedings. Unless part of a broader negotiation, a future tax refund related to a taxable year while married is commonly argued as marital property to be divided equally once received. However, such a refund can only be divided if it is identified or known by the spouse who may not otherwise be made aware of it.
Beware, as the opposite must also be true. If a significant tax liability is to be paid in the year following a divorce, but is born from income generated during the marriage, both parties may potentially share in the liability. Even if the liability is not calculated or paid until the year following the separation.
FAQ #6: Are proper tax withholdings made from alimony before I receive them?
The answer is no. If you receive alimony (subject to being in place before December 31, 2018 only), you may have to make estimated tax payments. If you don’t pay enough tax either through your other payroll withholdings from an employer or by making estimated tax payments, you may have to pay an additional penalty come tax season. Remember, receiving alimony as part of an agreement put into place after December 31, 2018 will qualify the recipient for the new, tax free treatment. As such, making estimated tax payments associated with alimony received will be no longer necessary.
FAQ #7: The end of the year is here and my divorce is nowhere close to being finalized. Should my spouse and I still file a joint return?
Unfortunately, this is another answer of it depends. However, it is worth noting that the answer we find in practice is often yes, you should still file jointly. This is most often attributable to more income being taxed in lower rate brackets relative to a married filing separately return. Because the income and tax situation of each client is unique, you should ultimately consult with your tax advisor and attorney to make this decision. This may be a great time for you to shop around for a new personal tax advisor if you no longer wish to use (or no longer trust) the same advisor working for your spouse.
It should go without saying that given the overall complexity and recent changes in tax law, you should consult your family law counsel and personal tax advisor on how best to handle your unique personal situation.
For additional information related to personal taxes in the year of divorce, please see another helpful article: The Taxing Side of Divorce: Taxes in the Year of Divorce.