Divorce is not a topic most of us like to discuss. The unfortunate reality, however, is the divorce rate in our society has hovered around 50% for the past several decades. When marriages dissolve, there are a lot of issues that must be addressed. Among the most critical is the affect the divorce has on the taxes of each spouse.
When divorces are finalized, couples sometimes believe the settlement is fine, only to encounter some very unpleasant surprises at tax time. Accountants often end up having to clean up the tax mess, and some issues may be impossible to reverse after the final decree has been issued.
There are three primary areas of a divorce in which there could be major tax consequences; child custody, alimony/spousal support and property division.
Child Custody: In years past, child custody agreements used to be fairly straightforward; one parent was awarded custody and the non-custodial parent typically had visitation rights every other weekend and a month of the summer or some similar arrangement. With a traditional arrangement, it was clear that the custodial parent would be the one to claim the child as a dependent and claim the child tax credit if they qualified.
Today, there are many shared/joint custody arrangements in which children are shuffled between parents each week. For example, they may spend Monday through Wednesday with one parent and Thursday through Sunday with the other; these arrangements are usually made to accommodate work schedules. The problem is deciding who will receive the tax benefits of the child. This issue should be worked out ahead of time so there is no major dispute later.
Spousal Support: Alimony/maintenance is tax-deductible for the payer and taxable income for the recipient. The problem is many spouses do not realize they are liable for taxes on this money until April 15. This can become a major financial burden if you are not prepared ahead of time. One creative solution some divorcing spouses use is called unallocated maintenance. This means payments for child support (which is non-taxable) and spousal maintenance is combined into one payment that is tax deductible for the payer and taxable income for the recipient. Why would the recipient want such an arrangement? Because it can often put the payer into a lower tax bracket and save enough money for the recipient to receive a higher award. Depending on the tax brackets of each spouse, this can be a tax benefit for both parties.
Property and Asset Division: When complex assets such as homes, retirement accounts, family-owned or closely held businesses and similar property are divided, it can have significant tax consequences. For example, there may be capital gains taxes for the sale of property and profit/losses for small businesses. Before beginning a divorce proceeding, it is important to speak with a local accounting firm about these issues so you can make sure the divorce is structured in a way that is financial advantageous for both parties.