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TAX CONSEQUENCES IN DIVORCE

Gene Brentley Tanner Sullivan & Tanner, P.A.

brentleytanner@ncfamilylaw.com | www.ncfamilylaw.com | (919) 832-8507

Gene Brentley Tanner is a partner at Sullivan & Tanner, P.A., where he currently represents

clients in all aspects of family law including separation agreements, premarital agreements,

postmarital agreements, custody and visitation, support matters, property division, complex

equitable distribution, military pension division orders, court orders acceptable for processing,

qualified domestic relations orders, and litigation and appeals.

Mr. Tanner earned his Bachelor of Arts in political science from the University of North Carolina

at Chapel Hill and his Juris Doctorate from the Norman Adrian Wiggins School of Law at

Campbell University. Mr. Tanner is a North Carolina board-certified specialist in family law. He

has been selected as a rising star in the North Carolina Super Lawyers publication and has

been elected to Business North Carolina magazine’s Legal Elite. He is a member of the Tenth

Judicial district bar, the Wake County bar association, the North Carolina bar association, and

the American Bar Association.

Mr. Tanner has published articles in the areas of family law in North Carolina Lawyer’s Weekly,

the Oregon Family Lawyer, the Michigan Bar Journal, the Pennsylvania Family Lawyer, the

North Carolina Family Forum, and in the American Academy of Matrimonial Lawyers. He has

presented at continuing legal education seminars in several states regarding military divorce

issues. Mr. Tanner represents clients in all counties within North Carolina and has appeared pro

hace vice in Massachusetts in a case involving complex issues regarding Survivor Benefit Plan

coverage.

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TABLE OF CONTENTS

1. Helping your client understand common tax issues in divorce …………………..3

a. Filing Status…………………………………………………………………..3

b. Child Tax Credit/Dependency Exemption …………………………………6

2. Tax Impact on Division of Assets and Marital Property ………………………….9

a. Individual Retirement Accounts………………………………………………..8

b. ODROs…………………………………………………………………………9

c. Property Settlements……………………………………………………………10

d. Principal Residence Exclusion…………………………………………………12

3. Common Income Tax Considerations in Alimony …………………………………14

4. Costs and Fees for Getting Divorced ………………………………………………..16

DISCLAIMER: The following materials and accompanying Access MCLE, LLC audio CLE program are for

instructional purposes only. Nothing herein constitutes, is intended to constitute, or should be relied on as,

legal advice. The author expressly disclaims any responsibility for any direct or consequential damages

related in any way to anything contained in the materials or program, which are provided on an “as-is” basis

and should be independently verified by experienced counsel before being applied to actual matter. By

proceeding further you expressly accept and agree to Author’s absolute and unqualified disclaimer of

liability.

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Helping your client understand common tax issues in divorce.

1. Filing Status

Clients will often ask the family law attorney, “How should I file my taxes this year?” The

answer is akin to adult diapers. Depends.

If you are married, you are limited to married joint or married separate except for a

period of separation allowing for head of household filing.

If you are divorced, you are limited to head of household if applicable or single filing

status.

What is “unmarried” as the IRS views it? You are unmarried for the whole year if either of the

following applies:

(a) You have a final divorce decree or decree of separate maintenance by last day of tax

year. Interlocutory decrees are not final.

(b) You have married annulled, which allows for prior modifications and amendments

which are beyond the purview of today’s time limits.

(c) For head of household filing, there are some additional requirements as set out below.

a. Must file a separate return

b. Must pay more than one-half cost of keeping up home for tax year

c. Spouse can’t live in your home during last 6 months of tax year. Keep in mind

that a spouse is considered to live in your home even if he/she are temporarily

absent due to special circumstances.

d. Your home was main home for child for more than one-half of tax year

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e. You must be able to claim child as exemption unless transferred. So long as

either spouse can claim qualifying child, you are good.

What are the different types of filing status? Let us explore them.

a. Married Joint— If you file married joint, you received the most substantial tax

benefit. However, filing married joint means that the two taxpayers (Husband

and Wife) are jointly and severally liable on the tax deficiencies that may

exist. If one taxpayer is unable or unwilling to pay taxes, the other spouse can

be made fully responsible for the entire amount of taxes owed absent an

exigent excuse which allows relief as provided for in the Internal Revenue

Code. If you file this way, any tax refunds shall be applied to a spouse’s debts

associated with other tax debts, child support or spousal support payments or

debts such as student loans. Lastly, filing married joint locks you into that

filing status unless you get relief for limited reasons. Otherwise, you are stuck

with married joint filing and you cannot amend to married separate.

b. Married Filing Separately – If you file married separate, it can be a double

edged sword for the tax filers. The benefits are that there is a separate liability

for taxes owed. Also, if you file married separate and want to file married

joint later on, you may do so within 3 years of filing. However, with the perks

come the quirks.

For one, a lot of credits and deductions are reduced or eliminated for

one or both of the tax filers when filing married joint. Examples

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include the inability to get earned income tax credit, limited child and

dependent care expenses, and reduced standard deductions if

applicable. In regards to the standard deduction, if one of the spouse’s

files married separate and itemizes deductions, the other spouse cannot

use the standard deduction. As to itemized deductions, the typical rule

is that you may only deduct the expenses actually paid. Thus, if you

paid one-half of a qualified mortgage interest payment, you may

deduct only one-half.

c. Head of Household – If you are able to claim this, you get the benefit of

claiming standard deduction (which is higher than single or married separate)

even if the other spouse files married separate and itemizes deductions. You

also have some credits and deductions available that are lost when filing

married separate. So…what does it take to file this way. You will have to

meet the following criteria:

You are unmarried or considered “unmarried” on last day of year

You paid MORE than one-half the cost of keeping up a home for the

year

1. *TIP* Keeping up a home means that you pay more than half

cost of upkeep for year which can include rent, mortgage

interest, taxes, hazard insurance, repairs, utilities and food

eaten at the home. Personal expenses will not count however.

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Qualifying person lives with you for more than one-half the year

(except for temporary absences)

Must file a separate return

Spouse can’t live in your home during last 6 months of tax year. Keep

in mind that a spouse is considered to live in your home even if he/she

is temporarily absent due to special circumstances.

1. *TIP* Special circumstances could be an illness, military

deployment, business travel, education, vacations. The inquiry

is whether it was expected that the person would return.

Your home was main home for child for more than one-half of tax

year

You must be able to claim child as exemption unless transferred.

d. Single – you are not married and you do not qualify for head of household

status. Be prepared to pay out the wazoo.

2. Child Tax Credit/Dependency Exemption

For purposes of taking minor children as exemptions on your taxes, the default rule is that the

custodial parent is the individual who gets to claim the child(ren) on his or her taxes. Of course, a

parent who is paying child support but does not have primary custody will argue to they are blue

in the face as to why it is fair, just and equitable that he or she get to claim the kids since they are

financing the children. However, that conversation always ends with too bad so sad unless you

can wheel and deal.

In order for a non-custodial parent to get the child as an exemption if any of the following is

applicable:

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(1) The parents:

a. Parents are divorced or legally separated under a decree of divorce or

separate maintenance;

b. Parents are separated under written separation agreement; or

c. Parents lived apart at all times during last 6 months of the year,

whether married or not

(2) Child received over half of his or her support from parents (not just one parent

but both is suitable)

(3) Child is in custody of one or both parents for more than one-half of year

(4) Custodial parent has transferred the right to claim the child

a. *TIP* The year that the decree went into effect will determine whether

the Form 8332 (or other similar declaration) must be submitted or if

the underlying agreement will suffice. If the decree is 2008 or before,

you can submit pages of the decree/agreement so long as language in

the instrument requires the transfer and specifies the years applicable

for the transfer. If the decree is 2009 or after, must submit Form 8332

or similar statement.

b. *TIP, part Duex* The custodial parent may revoke a release of claim

given under 8332 but must give notice or made reasonable efforts in

the prior year(s). If you try to revoke during the taxable year, it is not

acceptable.

What if the child(ren) spend equal time (nights) with both parents so that there is no true

custodial parent? Well, absent a decree/agreement to the contrary, the parent with the

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higher adjusted gross income will get the child as an exemption. Now, how do you split

365 days into equal overnights…I think we may have to ask the Tootsie Pop owl.

What benefits does taking the child as an exemption get you? You can get not only the

exemption but the child tax credit, possible head of household status, dependent care

expenses, exclusion from income for dependent care benefits, and earned income tax

credits. You cannot negotiate those. You either have them with the exemption or you do

not.

Seems rather simple, right? Good, let’s complicate things. If the non-custodial parent gets the

child exemption, then that child will not usually qualify for head of household filing status.

Also, it is not required that a parent claim dependency exemption to get dependent care

credit.

Also, parent not claiming child may still get the deduction for employer provided health

and welfare plans as well as HSAs, MSAs and Medical Expenses Paid.

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Tax Impact on Division of Assets and Marital Property

a. Individual Retirement Accounts

i. Transfer under IRC 408(d)(6) allows for transfer without QDRO. Also, if

trustee to trustee rollover, can avoid tax and penalties so long as IRA to IRA

transfer.

ii. Rule 72(t) Penalty Exception -- IRS does permit early access to IRA prior to

required age before penalty of 10% if taking under plan of substantially

equally periodic payments. These payments must continue for longer of 5

years or until age 59.5.

iii. Spousal IRA Contribution – If final divorce decree is obtained by end of tax

year, spouse can’t deduct contributions made to former spouse’s IRA.

iv. Taxable alimony received is treated as compensation for purposes of IRA

contribution and deduction limits.

v. The 10% penalty exception for higher eduction expenses does not count for

former spouses (but can for spouses)

vi. First time homebuyer $10,000 penalty free withdraw doesn’t apply to former

spouses.

vii. If funds from IRA are garnished for child support, amount paid out is taxable

to IRA holder as income and penalty can also apply. See T.C. Memo 1997-

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viii. Can you borrow in IRA? NO!

b. QDROs

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i. If you rollover funds within 60 days of Plan Administrator’s notice to the

former spouse, then it can be tax-free.

ii. Must roll over into another qualified plan/account or IRA…sorry, checking

account doesn’t apply.

iii. Any funds not rolled over subject to automatic 20% withholding and 10%

penalty if under 59.5 years of age.

iv. Roll over into Roth IRA is possible but you need to have clients consult a

CPA to discuss this in greater detail.

c. Property Settlements

i. Section 1041 exchanges

1. No recognized gain/loss on transfer of property to former spouse

property incident to divorce.

2. Incident to divorce means that:

a. Transfer occurs within 1 year after divorce; or

b. Related to the divorce, which means that the transfer is made

under divorce/separation instrument and occurs within 6 years

after final decree of divorce.

3. Not applicable if:

a. Spouse or former spouse is nonresident alien

b. Certain trust transfers that create installment obligations or

transfer of property in trust where liabilities assumed by trust

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or which encumber property exceed the total adjusted basis of

transferred property.

i. *TIP* If transfer of property subject to trusts involved,

simple rule is trust but verify. Get a CPA.

c. Certain stock redemptions taxable under Reg. 1.1041.2

ii. You can transfer HSA benefits without tax consequence.

iii. Basics of Transferred Basis

1. The basis in property received by former spouse is the same as the

other spouse’s adjusted basis.

2. Be mindful of the Carryover basis as it relates to the value of the

property being transferred.

iv. Capital Loss Carry Forwards

1. These may not be allocated b/w parties; the losses are recognizes by

the spouse who incurred the loss and joint accounts shall be split

50/50. See IRS Reg. 1.212-1(c)(1)(iv).

2. These can be carried over for unlimited time until fully used up. See

IRC 1212(b)

3. If you have a case where there is unused passive activity losses, you

better better better get a CPA. Why?

a. The transfer of the underlying passtive activity property can

affect basis of property if made incident to divorce but since

transfer is not taxable, not carryover of passive activity losses.

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Thus, benefit not realized until property disposed of. Get

Form 8582.

b. The losses may be lost by the transfer to former spouse.

c. If the transfer is a taxable exchange, the suspended losses may

be applied against all income sources.

v. AMT Credit Carryforward – Not real guidance. Run like hell!

vi. Charitable Contribution Carryforward – Under IRS Reg. 1.170A-10(d)(4),

these shall be split in proportion to what charitable contributions and

resulting carryforwards would have been paid if filed separately. Same

principle applys to net operating losses under IRS Reg. 1.172-7(d). NOL are

those excess of business deductions over all income see IRC 172.

vii. General Business Credit Carryforard – goes with business.

viii. Gift Tax Issue

1. Transfer of property not subject to gift tax if any of the following

applies:

a. Made in settlement of marital support rights, so long as value

of property transferred not more than value of those rights.

b. Marital deduction applies, that is, transfer to spouse before

final decree of divorce or separate maintenance.

c. Transfer under divorce decree or incorporated agreement

d. Transfer under written agreement so long as divorced within 3

year period starting 1 year before and ending 2 years after the

date of agreement.

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d. Principal Residence Exclusion

i. $250,000 for individual, $500,000 for joint filers

ii. Must be principal residence….but what does that mean?

1. A taxpayer may use the exclusion each time a home is sold provided

two years have lapsed since the last sale.

2. To qualify, a taxpayer must own and live in the home as a principal

residence for two of the five years preceding sale.

3. “Tacking” of Ownership – If an interest in the marital residence is

transferred from one spouse to the other pursuant to the divorce, the

transferor’s period of ownership passes with the property to the

transferee.

4. Attribution of Use - If it is expressly provided that one spouse is

entitled to remain in the home until it is sold, that spouse’s “use” is

attributed to the other spouse even if that spouse is not using the

residence.

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Common Income Tax Considerations in Alimony

a. Alimony is taxable income to the recipient and tax deductible for the payor.

b. Alimony must meet the criteria as set out in IRC Section 71. That is, it must be:

iii. Can’t file together on taxes

iv. Doesn’t relate to property distribution

v. Cash or cash equivalent

vi. Made pursuant to written decree/agreement/separation instrument

vii. Can’t be child support.

1. *TIP* If underpayment and child support in play, funds paid go to

child support first.

2. *TIP* Also, don’t make alimony contingent on facts that make it

appear as child support.

viii. Spouses can’t live together under same household.

1. *TIP* You are not treated as members of same household if one

spouse is preparing to leave and does leave no later than 1 month

after date of alimony payment.

ix. No liability after death of recipient spouse.

c. Payments to third party can count if ordered/agreed to pay such expenses. If paying

home expenses, it gets a little more intricate depending on title and the expenses

paid.

d. Life insurance premiums = alimony if the recipient spouse owns the policy.

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e. Alimony Recapture – If your alimony payments decrease or end during the first 3

calendar years, you could be in recapture arena. If you are, you must include in

income in the third year part of the alimony payments you previously deducted.

f. You are subject to this if alimony paid in 3rd

year decreases by more than $15,000

from 2nd

year or alimony paid in second and third years decreases significantly from

amount paid in first year.

x. 3 year period starts with first calendar year you make payment as alimony.

xi. Does not include temporary support orders.

xii. Reasons for reduction may include:

1. Planning Oops

2. Failure to make payments

3. Modification of instrument

xiii. Don’t count period if payee spouse remarried before end of third year or

either spouse dies.

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Costs and Fees for Getting Divorced

The parties to a divorce can deduct legal fees paid for tax advice in connection with a divorce

and also legal fees to get income producing benefits in a divorce. Simply put, tax advice legal

fees are deductible but must prove the differentiation between those types of legal fees and other

fees used to procure the divorce and property settlement. For fees related to income producing

benefits, you can deduct those subject to the 2% limit. Lastly, keep in mind that some fees

associated with property settlement can be added on the adjusted basis for a party receiving

property.

Deductible:

Legal fees for tax advice and for obtaining taxable support/income

Not Deductible

Legal fees, court costs, etc. for divorce, custody, child support, other nontaxable issues.

Cancellation of debt is usually treated as income under IRC 61(a)(12). However there are some

notable exceptions:

1. Bankruptcy

2. Insolvency when debt cancelled

3. MDRA of 2007

Mortgage Forgiveness Debt Relief Act of 2007 – allowed for a mortgage debt discharged to not

be treated as taxable income between Jan. 1 2007 and December 31, 2009. This was extended by

Emergency Economic Stabilization Act of 2008 to end of December 2012. Does not cover home

equity loans that aren’t used to improve property.