My wife, Maurine, and I will be “celebrating” our 25th wedding anniversary next month, in October, 2010. In honor of this milestone, I decided to explore the Federal Income Tax aspects of divorce in this installment of Tax Law Explained.
Generally accepted statistics show that, in the United States, roughly 50% of first marriages end in divorce. This increases to 66% for second marriages and 74% for third marriages. While my marriage may be made in heaven, the Tax laws relating to divorce are made in Washington D. C. Because of this, it is important to understand the Tax implications, planning opportunities and pitfalls of divorce well before the divorce is finalized.
Marriage: A Word Or A Sentence:
You cannot get divorced if you were never married. So, what does “marriage” mean? The same Congress that debated in 1998 with President Clinton over whether “is” means “is” warmed up in 1996 over the question of whether “marriage” means “marriage”. The Federal Defense of Marriage Act of 1996 (DOMA) defines marriage as “only a legal union between one man and one woman as husband and wife” and the word spouse as “only to a person of the opposite sex who is a husband or a wife.” Accordingly, only those who are considered to be married under DOMA are considered to be married under the Federal Income Tax laws.
Each taxpayer has a “Filing Status” for their Individual Income Tax Return (Form 1040). Determining the proper Filing Status can sometimes be tricky but here are some basic guidelines:
- If you are married at the end of the day on December 31st of the applicable tax year you can either file as “Married Filing Jointly” or as “Married Filing Separately”.
- You must file as “Single” if, at the end of the day on December 31st of the applicable tax year you were either:
- Unmarried (never married, divorced or annulled); or
- Married but legally separated.
If you have your marriage legally annulled you are treated as though your marriage never existed. If your marriage never existed, you are required to go back and amend your tax returns for all “open” tax years in which you filed as Married to change the status to Single.
- Under certain circumstances, a person who would otherwise file as “Single” may be able to file with the Filing Status of “Head of Household”.
Children and Dependents:
There are a number of Federal Income Tax benefits given to those with children or other dependents. The laws relating to whether one or the other parent can get tax benefits for children are quite complicated and beyond the scope of this article. Factors that an affect this include, but are not limited to: who is the custodial parent, where did the child live during the year, who provided what support, the age of the child, whether the child is single or married, whether the Divorce Decree specifies who can claim the child, whether a release of rights is executed by one parent (IRS Form 8332), etc. For more details, see IRS Publication 501.
People who file as Married Filing Jointly are joint and severally liable for all tax liabilities, including penalties and interest. This cannot be overridden by a divorce decree that states that only one of the former spouses is responsible. Under certain limited circumstances, relief can be granted to a spouse (e.g. Innocent Spouse Rule).
However, even before divorce, if one spouse is concerned about what the other spouse may be including (or not including) on their Married Filing Jointly Return, or that they will not be able to pay their tax (and it is due to income/withholding issues of their spouse and not them) they should consider filing as Married Filing Separately.
In general, the divisions, separations and transfers of property made pursuant to a Divorce Decree are not considered to be taxable events. That is, there is no income, gain, loss or deduction. This is true whether the asset is a Traditional IRA, a house, stock or land. However, this does not mean that there might not be significant Income Tax consequences when the ex-spouses go to sell those assets or withdraw from a Traditional IRA.
The tax basis of an asset for Income Tax purposes (“Basis”) is the figure used to determine whether a taxpayer has a gain or loss when they sell that asset. While in most cases Basis is what a person paid for that asset there are many exceptions. In general, the Basis of assets that an ex-spouse obtains in a divorce settlement is carried over from whatever the Basis was at the time of the transfer.
The IRS Sayeth: Not All Assets Are Created Equal:
If Husband and Wife each get assets with a Fair Market Value (“FMV”) of $1,000,000 it does not mean that they will end up with $1,000,000 after they turn those assets into cash. The Federal Income Tax laws could operate to provide dramatically different tax consequences to ex-spouses. Accordingly, assets should have to be carefully investigated and selected for division in a divorce.
Here are 4 examples:
Let’s say that Husband and Wife jointly purchased 2,000 shares of Google, Inc. for $200/sh in 2005. Their Basis in each share is $200 and total Basis in all shares is $400,000 (2,000 shares x $200/sh = $400,000). Wife gets the 2,000 shares of Google, Inc. as part of the divorce settlement at a time when they are trading at $500/sh (2,000 shares x $500/sh = $1,000,000). Wife’s Basis in each share is $200 ($100/share for her 50% ownership portion and $100/share for Husband’s 50% ownership portion). If Wife then sells all 2,000 shares for $1,000,000 she will have a taxable gain of $600,000 ($1,000,000 – $400,000 = $600,000). If the shares were sold in 2010, the gain will be taxed at a favorable 15% long-term capital gain rate resulting in a tax cost of $ 90,000. If Wife had $ 100,000 of capital losses from other securities (or carryovers), she could reduce the net long-term capital gain subject to tax to $500,000 ($600,000 – $100,000 = $500,000) resulting in a tax cost of $75,000.
Let’s say that Husband had a Traditional IRA with a FMV of $2,000,000 and that Wife gets 50% of this (i.e. $1,000,000) as part of the divorce settlement. Since this is a Traditional IRA, any amounts withdrawn will be taxable at ordinary income rates. Further, if Wife makes withdrawals before she reaches age 59-1/2, Wife may have to pay a 10% Early Withdrawal Penalty in addition to the income tax. If Wife withdraws the entire $1,000,000 that puts her in a 33% marginal bracket, she will have a tax cost of $333,333. If she is under age 59-1/2 (and does not meet any exception) she will have to pay a $100,000 penalty bringing her tax cost to $433,333. In this situation, Wife got the same $1,000,000 of assets as in Example 1 above, but her net after-tax benefit is much lower. If Wife elects to forego withdrawals until forced to do so under the Minimum Distribution Rules, she can defer (but not avoid) the income tax on those withdrawals.
Let’s say that Husband and Wife jointly purchased their principal residence in 2005 for $400,000 (including legal fees and other closing costs). Their Basis in the house is $400,000. Wife gets the house as part of the divorce settlement at a time when the FMV of the house is $1,000,000. Wife’s Basis in the house is $400,000 ($200,000 for her 50% ownership portion and $200,000 for Husband’s 50% ownership portion). If Wife then sells the house for $1,000,000 in 2010 she will have a gain of $600,000 ($1,000,000 – $400,000 = $600,000). However, assuming she qualifies (owned and used the home as her principal for at least 2 years, no business use of home, etc.), Wife can exclude $250,000 of this gain leaving her with a taxable gain of $350,000 ($600,000 – $250,000 = $350,000). If sold in 2010 and taxed at a favorable 15% long-term capital gain rate, the resulting in a tax cost is $52,500. If Wife happened to have capital losses from other securities (or carryovers), she could further reduce the net long-term capital gain and resulting tax.
Let’s say that Husband and Wife jointly purchased their principal residence in 2005 for $400,000 (including legal fees and other closing costs). Their Basis in the house is $400,000. However, instead of transferring the house as part of the divorce, Husband and Wife sell the house in 2010 for $1,000,000 and split the net cash. Husband and Wife will have a gain of $600,000 ($1,000,000 – $400,000 = $600,000). However, assuming they both qualify, Wife can exclude $250,000 of this gain and Husband can exclude $250,000 of this gain. In this situation, the combined taxable gain is only $100,000 ($600,000 – $250,000 – $250,000 = $100,000). If sold in 2010 and is taxed at a favorable 15% long-term capital gain rate, the resulting tax cost is $15,000.
Payments made pursuant to a divorce decree that are designated as alimony (as well as certain types of separate maintenance designated in a separation agreement) may have Federal Income Tax consequences to both spouses. They are generally included as ordinary income on the tax return of the recipient and deductible on the tax return of the payer. To qualify as “alimony” for Federal Income Tax purposes, certain requirements must be satisfied and the requirements are different based upon whether the legal instrument that gave rise to the payment was executed before or after 1985. Child Support is not alimony. For more details, see IRS Publication 504.
Costs of Divorce:
Generally, costs incurred relating to divorce are not deductible. However, fees paid for advice relating to the tax aspects of divorce may be deductible. This could include advice relating to Federal, state and local income tax, Federal and state Estate and Gift tax, real estate tax and alimony. If so, they are deducted by the person who paid them, in the year paid, on Schedule A (Itemized Deductions) as a Miscellaneous Itemized Deduction, Subject to a 2% Floor. Attorney’s should break out their invoices in such a way that their clients can identify the portions that could be deductible.
Social Security Number:
People who are recently divorced should confirm that their name matches with their Social Security Number. If you changed your name, you must contact the Social Security Administration to update their records. If so, you should complete and file Form SS-5 with the Social Security Administration.
It should be noted that certain Tax laws relating to people who live in community property states can be different based upon the impact of the community property laws. This article relates to people who live in Illinois and does not fully explore how community property laws affect the Federal Income Tax laws.
The emotional and financial struggles associated with divorce can be quite challenging. However, Family lawyers and tax advisors should not lose sight of the Tax consequences. In some situations, the Tax aspects can provide an opportunity for bridging the settlement gap. In no situation would an ex-spouse want to be unhappily surprised by a bad Tax result that they had not been advised of.
Copyright ©, Keith B. Baker – 2010
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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Any discussion of federal tax issues in this correspondence may constitute “written tax advice”. Any such advice is limited to the issues specifically addressed, and the conclusions expressed may be affected by additional considerations not addressed herein. Any tax information or written tax advice contained herein (including any attachments) is not intended to be, and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. (The foregoing legend has been affixed pursuant to U.S. Treasury Regulations governing tax practice.)
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