Tips for Avoiding Taxes on a Divorce Settlement

Getting a divorce could have a profound impact on many aspects of your financial life. You may need to learn how to manage your money once you are newly single. You may also need to learn how to cope with the changes that come from ending your marriage.

Obviously, the first issue you'll face is the cost of the divorce itself, as the process might be expensive. But you should also be aware of the fact that ending your marriage could impact your taxes, too. Failing to plan for this could be a costly divorce mistake, but this guide might help you understand how to minimize or avoid a big IRS bill in some of the most common situations created by the end of a marriage.

Alimony payments

Alimony payments are money paid to an ex-spouse. A higher-earning spouse may be required to make these payments as part of a divorce decree. But various factors go into a judge’s decision to grant alimony, and not every divorce includes alimony.

While alimony payments used to be considered deductible for the person who made the payments, this changed with the passage of the Tax Cuts & Jobs Act of 2017.

Alimony payments made under divorce agreements executed or modified after 2018 are no longer deductible by the payer spouse or considered taxable income for the receiving spouse.

For divorce agreements executed or modified on or before Dec. 31, 2018, the previous tax rules still apply unless the terms of the alimony changed or the agreement or modification specifically mentions the deductibility or taxable status of the alimony payments.

Marital property settlements

Property is often transferred between divorcing spouses as part of a divorce agreement. For example, money or a shared vehicle may be transferred from one spouse to another in order to make sure each partner gets their share of the joint property acquired during the marriage.

When a marital property settlement occurs, it is generally not taxable if it is "incident to the divorce," which is a way of saying it’s related to the divorce. The transfer of property is considered to be incident to the divorce if the ownership shift occurs within a year of the marriage ending.

What if a transfer occurs more than a year after the marriage ends? The same tax rules will still apply, and no taxes will be owed if the transfer occurred within six years of the divorce because of a divorce settlement decree. The change in ownership would still be considered to have occurred "incident to the divorce," and no taxes will be assessed.

However, if a transfer occurs after one year and before six years of the end of the marriage but it was not a part of a settlement decree, it would be taxable. Lastly, if a transfer happens after more than six years, it typically won't qualify for the same tax treatment, and taxes could be owed.

Tax basis transfers

It's important to understand how the tax basis works when a property is transferred in a divorce. The tax basis is the value of the investment for tax purposes. It's used to determine things like capital gains or losses. For example, if you buy a stock for $1, your basis is $1. If you sell it for $2, then you would have a $1 gain that you owe capital gains taxes on.

The basis could have certain tax consequences when transferring property because it could affect your future tax bill. If the property is transferred incident to the divorce, then the basis of the property is the adjusted basis of the transferer. This means if your spouse purchased a house for $200,000 and it's transferred to you when its value is $500,000, your "basis" is still $200,000 for purposes of determining whether you owe future capital gains taxes on that home’s sale and how much those taxes will be.

In some cases, couples may decide that they want to treat the transfer of assets as a true sale rather than a transfer incident to the divorce. This can help to reduce future capital gains taxes later.

For example: A married couple purchased a home together for $400,000, with each owning a 50% share. If the home's value had increased to $800,000 at the time of divorce, it could be transferred as incident to the divorce. If the wife transferred her interest to the husband under these tax rules, his basis would be $400,000 — their combined basis. He would need to wait at least a year after the transfer to avoid paying short-term capital gains taxes. If he sold it for $800,000, he would owe capital gains taxes on $400,000.

On the other hand, if the transfer were treated as a true sale, the wife would receive $200,000 in gains on her half of the $400,000 profits. The husband would then have a new basis of $600,000. This is the sum of the original $200,000 basis plus $400,000 from the sale. So if he sold the house for $800,000, his gains would be just $200,000 rather than $400,000 in the case of a tax-free transfer.

That’s why it’s important to carefully consider how tax basis transfers can affect your future tax liability. This could guide your decision regarding having a tax-free transfer.

Tax breaks for divorced couples

Divorce could affect your tax returns in other ways beyond just issues related to the taxation of alimony or transferred property. Here are some examples.

Marital status

When you were married, you had a choice of filing a joint return or separate income tax returns. Once you are divorced, these filing statuses will no longer be available to you. You may only be eligible to file as single or as head of household if you have qualifying dependents.

This might change your tax bracket. Say, for example, that you worked but had a stay-at-home spouse. You might have been in a lower tax bracket when you were married. But if you divorce, you might now be in a higher bracket and could owe more in taxes since you don’t receive the same tax exemption.

Some tax deductions and credits are also means-tested, which means if you earn more than a specific amount of money you lose access to them. The thresholds for losing access to these tax breaks are usually lower for singles or heads of households than for married couples.

It’s essential to remember that finalizing a divorce doesn’t end your tax liability toward the divorce agreement and the exchange or transfer of assets. The IRS could perform random audits of a divorced couple’s tax return for up to 3 years. This period could even be extended to 7 years if the IRS believes it has a good cause for performing an audit.

A divorced couple could include a provision in the divorce agreement that outlines how potential penalties or taxes would be addressed. This provision would define where the funds would come and how the two former partners would pay for any expenses linked to the audit.

Home sale

The rules for excluding capital gains taxes on home sales could also differ when you are divorced. Married couples could exclude up to $500,000 in gains on their home sale if they file jointly and meet certain requirements, such as living in the home as their primary residence for two of the last five years. But singles could exclude only $250,000 in gains.

Because more gains can be excluded for married couples than for singles, it may make sense to sell the home before divorcing if you are ending your marriage and neither party intends to keep the property post-divorce.

Child care

If you have children together, there might be a number of potential tax credits and deductions that could be available to you. As a married couple who filed jointly, it was easy to claim these tax breaks on your shared return. But if you are divorced, you'll need to know which parent is eligible for the savings.

In most cases, the custodial parent could claim the child as a dependent and might be entitled to any tax credits that having that child entitles them to. This could include the child tax credit, as well as the earned income tax credit. If you pay medical bills for a dependent child, you could also claim a deduction for medical expenditures that exceed 7.5% of adjusted gross income.

There are circumstances where the non-custodial parent may wish to claim these credits, though. Under family law, the custodial parent will need to sign a form that releases their ability to claim the child on their taxes to the non-custodial parent. Parents may wish to negotiate on this issue as part of their divorce settlement if one parent has much more taxable income than the other.

IRA contributions

When alimony was considered taxable income for the recipient, it was possible to make IRA contributions with it and thus reduce the tax implications of receiving this money. However, that's no longer the case for most divorce agreements executed or modified after 2018.

IRA contributions could be made only from earned income you pay taxes on. So if you are receiving alimony, you won't be able to use it to make deductible contributions to this type of retirement account.

Contributions made to a retirement account throughout the marriage might be divided during the divorce process. The exact portions would depend on each state's laws; however, the IRA account usually remains the property of the original owner.

IRA funds could be transferred from one former spouse to another at a cost of 20% federal income tax for the recipient. To avoid this, the funds would need to be rolled into a new IRA account using a Qualified Domestic Relations Order (QDRO).

You would not be subject to income taxes when the funds are directly moved into an IRA account. However, the same rules that apply to IRA distributions will apply to these funds, including penalties for early withdrawals.

FAQs

Bottom line

Divorce is bound to raise important financial questions. You might be trying to figure out how to leave a marriage with no money or how divorce will affect you as a taxpayer. What’s important is to be as prepared as possible for the implications that ending your marriage could have on your money.

Further understanding of your financial situation beyond tax issues could be essential. A financial advisor could help you to get your most important questions answered during and after the divorce process. This could help you make the right money moves before divorce, as well as after a judge has dissolved your union.

You might consider contacting a tax professional or divorce attorney to get the advice you need to make the best choices during the divorce process.