Income Tax Tips For Divorcing Couples

How To Avoid Unnecessary Tax Troubles During Divorce

By Richard Streitfeld, CPA, CFE

Impoverishing One Impoverishes All

If at all possible try to think and act as an economic unit, at least until the divorce is final. You are right – and you do need to have your financial needs met in a fair and equitable fashion. However when one party tries to grab all the income tax benefits at the expense of the other, all may lose out – less money for the kids, more money for the lawyers. For instance if Sharon refuses to sign a joint return while the divorce is in process and Greg makes more money, she may save $500 but he may lose $5,000.  This may make Sharon happy, but may also make a settlement more elusive, drag out the proceedings and make it more difficult for Greg to provide for his share of any agreement. A better way? Sharon agrees to file jointly, but in exchange Greg pays her the $500 she would have received had she filed separately.

Thinking as one unit often means continuing to file “married joint” until the divorce is final. Why? Married filing separate brings higher tax rates and the loss of valuable tax benefits, especially related to kids and education. Deductions and dependents have to be allocated – no, the tax service will not let both of you claim Junior or the interest on your mortgage. Own rental property? Your maximum loss may be 50% – or zero.

That said, there are situations where a joint return is not advisable, or simply impossible. You may be suspicious of your spouse’s business tax reporting or wary of being responsible for his pre-marital tax debts. You may have such a disparity in personal income that the benefits of joint filing are reduced or even eliminated. Or maybe relations are so bad between you that you cannot manage the details of splitting a joint tax refund – or payment, so you forego it altogether.

Document Who Gets The Child Income Tax Deduction

[Editor’s Note: You can do this when you divorce (multiple years into the future) or each year when you both file your taxes (a single year), the form is the same.]

Who claims the child or children? Often couples will decide to alternate, even if one has actual physical custody. Sharon claims Junior this year, Greg takes him next year – and this is memorialized in their divorce agreement. In the eyes of the IRS, however, your divorce agreement is not sacrosanct and any dispute will be trumped by “facts on the ground”. So what does this mean?

Next year arrives, they are divorced, and Sharon is upset that Greg is behind on paying child support. She decides to claim Junior on her taxes. Greg goes by their divorce agreement and claims Junior as well. The IRS disallows both deductions until it can determine who the “custodial parent” is. Greg submits the divorce decree, Sharon submits documentation that Junior stayed with her “the majority of the nights”. A few years ago the IRS explained that it would side with the actual custodial parent, regardless of the divorce terms. Sharon wins.

How could Greg have prevented this travesty – after all, he negotiated and planned for claiming Junior at least half the time. At the time of their divorce settlement, he needed to have Sharon (the custodial parent) certify her release of the child dependency exemption for those specific future years he would claim it by filing IRS Form 8332, and then attach a copy of the signed form to his tax return. Then she cannot override his exemption even if Junior was there 366 days. She has released her right to the exemption for that year.

Other Income Tax Considerations For Divorcing Couples

Divorce and the IRS Tax Code – not to mention human relationships – are all exceedingly complex. Here are a few other issues to be aware of while you navigate this difficult process.

1.  Child support is not taxable to the recipient or a deduction for the payer. Alimony is taxable to the recipient and a deduction for the payer. But child support is generally statutory – controlled by legal guidelines in each state.
2. Are you married but living apart from your spouse for the last six months of the year? If you are supporting a dependent you may be eligible for “head of household” status, which is far more beneficial than married “filing separatly”. However, very specific conditions must be met, and both parents may not claim the status for the same child.
3. Negotiating for property ownership but thinking you may need to do a “short sale” down the road?  There can be adverse tax consequences if that happens – you could be taxed on the amount of the forgiven mortgage. There are protections in place to prevent this, but some of them are scheduled to expire at the end of 2012 and/or do not apply to a second home.
4. Is  your tax status changing? You may need to change your salary withholdings or estimated payments. You do not want to get caught by surprise on April 15 – and even if it’s a good surprise you very well might prefer that larger refund in your weekly paycheck.
5. Think carefully about how your dependency deductions may impact applications for college financial aid. Colleges that rely solely on the government financial form (FASFA) do not directly take in to account the second  parent’s income once you are divorced. Private schools and some public universities are more likely to utilize other financial forms as well, that do require disclosure of both parents’ income and assets.