Potential Tax Traps In Separation Or Divorce
By: Beverly Brautigam, CPA and Hal Bartholomew, CFLS
Are you separated from your spouse or thinking of dissolving your marriage? Over half of all California marriages end in divorce. The statistic is even higher for second marriages. You may think that separating from your spouse or getting a divorce isn’t any of Uncle Sam’s business, but either of these changes could affect your tax picture. Your filing status for your returns is determined as of your marital status on December 31 of the tax year. The filing status options are: single, married filing a joint return, married filing a separate return, head of household and qualifying widow(er) with dependent child.
Consideration should be given to how tax returns will be filed. As each spouse is joint and severally liable for any taxes and interest and/or penalties on a joint return, it may be wise to file separate returns. If separate returns are used in a community-property jurisdiction, as in California, the general rule is that each spouse must report one-half of the community income and all of his or her separate income. However, the combined tax from two married-filing separate returns is generally greater than the liability for a joint return. There can often be tax savings by finalizing the marital status by year-end enabling the parties to each file as a single taxpayer (avoiding the marriage tax penalty). It is best to have your specific situation evaluated.
Community income includes earned income until the date of separation.
If you choose to file separate returns, any withholding, estimated tax payments made and/or applied overpayments during the year can be allocated between spouses by writing to the IRS or the Franchise Tax Board detailing how the payments should be applied. The letter should be signed by both spouses.
If there are children of the marriage and the children qualify as dependents, generally, the parent who has physical custody of a child or children for the greater portion of the year is entitled to the dependency exemption. For 2005, an exemption is worth $3,200 on the federal return and $265 on the California return. However, these exemptions are phased out when a taxpayer’s adjusted gross income exceeds a certain amount depending on filing status. Be sure that you can benefit from the exemption before arguing over it. The custodial parent can waive the dependency exemption to the noncustodial parent in writing by completing Form 8332.
Starting in 1998, taxpayers with a son or daughter, grandchild, stepchild or foster child who is a U.S. citizen, national or legal resident, is under the age of 17 and can be claimed as the taxpayer’s dependent can claim a credit of $1,000 per child. The credit is phased out at certain income levels depending on filing status. There is a complex formula for determining the limitations on the amount of the credit and its partial refundability against payroll taxes for taxpayers with three or more qualifying children.
The custodial parent is allowed a credit for child-care expenses incurred for children who are under the age of 13 and who are dependents of the taxpayer. The amount of employment-related expenses eligible for the federal credit is $3,000 ($6,000 for two or more children). Depending on the taxpayer’s adjusted gross income, the percentage of employment-related expenses that make up the amount of the credit varies from 20 percent to 35 percent. A divorced or legally separated taxpayer having custody of a child who qualifies them for the credit is entitled to it even though he or she has released the right to a dependency exemption.
Taxpayers must provide social security numbers for dependents and qualifying children for the child-care credit and dependency exemption. So if you hope to use either of these tax saving opportunities, be sure to have the required social security numbers. The head-of-household filing status provides favorable tax rates. An unmarried taxpayer who maintains as his or her home a household which, for more than half the year, is the principal place of abode of any unmarried child or stepchild or any other person who is a dependent of the taxpayer, qualifies for these rates. Unmarried taxpayers need not be entitled to claim the person as a dependent to qualify as head of household. There are different rules for spouses living apart for the last six months of the year. A married taxpayer must be entitled to claim their qualifying individual as a dependent in order to file head of household. Further, the dependent must be a child, an adopted child or stepchild.
In California, there is a six-month waiting period before a divorce can be final. Therefore, some consideration should be given to filing a Petition and serving the Respondent prior to July 1 of the year to have options available to plan for the tax consequences of your filing status. As an alternative, a judgment of legal separation can be obtained in California. There is no waiting period for a legal separation. When a legal separation is obtained, the parties are considered unmarried as of that date for tax purposes.
Child support payments made as required by a divorce or separation agreement are not included in the income of the payee, nor are they deductible by the payor.
Spousal support payments made as required by a divorce or separation agreement that meet several requirements can be deducted by the payor and can be taxable to the payee, provided that the agreement does not state that they are not deductible nor taxable. Sometimes, spousal support can be re-characterized as child support. The IRS calls spousal support that meets the requirements “alimony”.
If you are currently receiving alimony payments, you may be required to file and pay estimated taxes if any withholding you may have does not cover your tax liability. If your only income is alimony, you may still be able to make a deductible contribution to an IRA. Alimony is considered to be compensation for these purposes. As a general rule, legal, accounting, appraisal and other expenses incurred in connection with proceedings for separation or divorce are considered personal, nondeductible expenses. However, those expenses incurred to obtain and collect taxable alimony may be deductible. Fees incurred for tax advice are also deductible.
When dividing your property, keep in mind that transfers of property between spouses generally have no immediate tax consequences. However, future tax consequences need to be considered. As an example:
Which would you rather have, $10,000 cash or a lot worth $10,000? The cash has no tax consequences. However, the lot cost only $1,000. Upon sale, there would be a gain of $9,000, the tax on which would be the burden of the person who receives the lot in the settlement.
Homeowners may now exclude up to $250,000 ($500,000 in the case of a married couple) of gain from the sale of a principal residence. The taxpayer must have owned and used the home as his/her residence in two of the last five years before the sale. The law considers divorce situations, and there are rules that attribute residency to the spouse who may have moved out of the residence prior to sale. This tax break is reusable every two years. No longer does a divorcing couple have to be concerned about rolling over a gain and “trading up”. Any gain that exceeds the exclusion amounts would be taxed at the applicable capital gains tax rate. And there is more good news – California conformed to this exclusion and even used the same effective dates.
This article has only touched on the complexity of some of the rules that could affect your tax picture if you are separating or divorcing. You should always have your situation evaluated and be sure that you are adequately represented no matter how amicable things may seem.
Beverly Brautigam is a Certified Public Accountant with Brautigam & Co., (916) 849-7804, [email protected] . She holds an MBA in Taxation and is a Personal Financial Specialist. Hal Bartholomew is a Certified Family Law Specialist with Bartholomew & Wasznicky LLP in Sacramento, 916-603-2913, [email protected].