Tax Consequences to Consider During Divorce
October 25th, 2021
In the heat of intense divorce negotiations, it can be easy to lose sight of the long-term effects of your settlement or litigation decisions. When those effects include the IRS, the tax consequences of divorce can turn what seemed like a wise choice at the time into a costly mistake. Here are several tax consequences to consider during divorce.
How Does Alimony Affect Taxes?
The intersection of alimony and taxes is one of the most talked about tax consequences of divorce in recent years. On December 22, 2017, then-President Donald Trump signed the Tax Cuts and Jobs Act (TCJA), a tax reform bill that changed the way taxes apply to alimony payments. If your divorce was finalized before January 1, 2019, the spouse paying alimony was allowed to take a tax deduction for alimony payments. The recipient of the alimony then reported the spousal support as income and paid taxes on what he or she received. This generally meant that alimony payments were taxed based on the lower income bracket of the recipient spouse.
Since 2019, however, the roles are reversed. No longer will alimony reduce taxes for the payer or count as taxable income for the payee. Instead, the higher wage earner -- the one paying alimony -- will need to report and pay taxes on all income, including the part to be paid to an economically dependent former spouse. The difference between these tax consequences can be substantial, especially if there is a large gap between the parties’ incomes. You and your divorce attorney should account for the impact of taxes paid on alimony when negotiating the appropriate amount to be paid - and also received.
If you cannot come to an agreement, you or your spouse can also ask the Maryland divorce judge to determine whether an award of alimony is appropriate in your case. The law directs judges to consider a variety of factors in determining a fair and equitable alimony award. While none of these factors specifically mention tax consequences, they do include the financial resources, needs, and obligations of each party. Your Maryland divorce attorney can present the tax consequences of paying or not paying alimony as part of your case at trial to ensure that the tax consequences are considered as part of any alimony determination.
Does Child Support Count as Income for Taxes?
The TCJA means that child support and alimony payments are now treated the same way by the IRS. Child support payments are not tax-deductible. The government assumes that you will spend a significant part of your income supporting your children. Child support also does not count as income for recipient parents. They are not required to report or pay taxes on child support received according to a child support order.
However, unlike in the case of alimony, you cannot necessarily negotiate a different payment amount to make up for the tax consequences of paying child support. In most cases, Maryland child support orders are calculated based on the child support guidelines that are written into the law. That law does allow the court to deviate from the child support guidelines if the recommended amount is “unjust and inappropriate” as long as it considers the best interests of the children. Still, child support deviation is usually based on the child’s unique financial needs, not the tax consequences to the parents. Factors in support of deviation include:
- Health insurance costs
- Extraordinary medical expenses
- Child care expenses
- Private tuition
- Shared or split custody or extraordinary visitation
- Needs of the parents’ other children
- In-kind support (such as one parent paying the mortgage on the home of the other parent)
Each of these deviation factors are specific to the child being supported. The fact that a parent paying child support bears a higher tax burden than the parent receiving that support is true in most child support cases. However, it is unlikely that this disparity alone will support a deviation from the Maryland child support guidelines.
Who Gets to Claim Your Kid’s Child Tax Credit?
One way to offset the tax consequences of child support within your divorce settlement is to negotiate over which parent will claim the Child and Dependent Care Credit for each child each year. This applies to your federal income tax return, as well as your Maryland state income tax return.
As a general rule, the parent with whom a child spends more overnights during the year is entitled to claim that child as a dependent on their federal tax return. This allows the custodial parent to claim the child tax credit and reduce their adjusted gross income by a set amount ($6,000 in 2020). However, the noncustodial parent may claim the child instead if the custodial parent signs a Release of Claim to Exemption for Child by Custodial Parent each year. This can be beneficial if the noncustodial parent’s income is taxed at a higher rate, or if the custodial parent cannot take advantage of the full $6,000 tax credit (because they do not have enough taxable income or to avoid having the amount reduced because one or both parents earn too much).
At the state level, Maryland parents claiming the credit are entitled to 32.5% of the federal credit amount, up to an adjusted gross income of $20,500 for individuals, or $41,000 for married couples filing jointly. Maryland taxpayers can also qualify for an Earned Income Tax Credit and can subtract certain childcare expenses from their income for state tax purposes. Because of this, parties often negotiate to alternate claiming the children, or to allow the child support payer to claim the children as dependents and then pay the payee a portion of the child tax credit in addition to their regular child support.
COVID-19 Advanced Child Tax Credits
The question of who claims the children for tax purposes is especially important in 2021. The American Rescue Plan Act, part of President Joe Biden’s COVID-19 relief strategy substantially increased the value of the child tax credit for tax year 2021 (from $6,000 to $16,000 per child). Eligible taxpayers will receive advance payments of the 2021 child tax credit in monthly installments over the second half of 2021. In addition, unlike in previous years, parents claiming their children on their taxes will be entitled to the full amount of the credit even if they don’t owe that much in taxes. Right now, these changes only apply until the end of the year, but with the Coronavirus still a problem across the country, it could be extended to apply in 2022 as well.
If you and your spouse separated in 2021 or anticipate filing your 2021 tax returns separately, you should carefully consider who is entitled to the state and federal child tax credit, and be certain that any judgment orders both parties to file the necessary paperwork with the IRS to avoid unintended tax consequences of divorce. Otherwise, the primary taxpayer on your family’s 2020 tax return (or the parent claiming the children if filing separately) will be the one to receive the advance child tax credits even if they are not the parent who is paying the extra childcare expenses and remote schooling costs created by COVID-19.
Tax Consequences of of Divorce Property Distribution
Alimony and child support each present ongoing tax consequences that will affect taxpayers for years after the judgment of absolute divorce is entered. However, the year your divorce is finalized you may face some additional tax consequences as a result of the property distribution in your divorce settlement agreement or judgment following trial. Before you agree to any property settlement, you should speak to your divorce attorney, financial planner, and accountant to make certain you understand the tax consequences of divorce.
Income Tax on Rental Properties
In some high asset divorces, one or both spouses will anticipate using rental income from the real property they receive to supplement income and help maintain a high standard of living. When couples own multiple properties, renting those properties can provide a temporary boost of income and ease the transition to a single income household.
However, owning a rental property has complicated tax consequences. The party receiving the rental property in a divorce will need to:
- Report the rental income on his or her tax return
- Deduct maintenance and upkeep costs (including mortgage interest payments and HOA dues)
- Deduct depreciation on improvements and repairs made on the property over several years
- Apply the Qualified Business Income deduction to pass-through income from any rental property business entity (if they created an LLC or S-Corporation for property management)
Before deciding whether to rent out a marital home, you should discuss these tax consequences of divorce with your accountant. That way you will know the net income value of the property and can set aside enough savings to pay for the income tax on rental properties awarded to you in the divorce.
Capital Gains Taxes on Property Sold After Divorce
Often parties will decide or be ordered to sell a marital home after divorce and split the net proceeds. However, depending on how you effectuate the sale, this can have tax consequences, too. If you sell your house together, you may end up paying capital gains tax on the proceeds. If the property sold was your primary residence for 2 of the last 5 years, you can exclude up to $250,000 per person, or less if you purchased the home in the last 2 years. However, any capital gains above that amount will have tax consequences.
If, instead, one spouse buys out the other spouse’s share of the equity in the property as part of the judgment, capital gains will not apply because the sale is part of the divorce. However, if the new sole owner of the home later decides to move out and sell the property, that party will bear all the capital gains tax consequences.
Early Withdrawal Penalties on Retirement Accounts
One last tax consequence to consider during divorce involves tax-deferred retirement accounts including 401(k) and 403(b) accounts. Contributions to these accounts are made with pre-tax money. The taxes are paid when the money is withdrawn -- generally in retirement. However, if you make an early withdrawal from a tax-deferred retirement account before age 59 ½, you will incur a tax penalty of 10% on top of those taxes.
Often, in divorce negotiations, retirement accounts are used to offset other valuable objects, including the marital home. The transfer of pre-tax dollars from an account in one spouse’s name to the other as part of a divorce using a Qualified Domestic Relations Order (QDRO) for 401(k)s or an Eligible Domestic Relations Order (EDRO) for 403(b)s does not trigger tax consequences. However, if the person receiving the retirement account plans to use that money to purchase a new home, for example, they will incur the taxes and penalties associated with early withdrawal. If that is your plan, be certain your attorney negotiates an appropriate setoff to account for the net value of the funds, rather than their gross value in the retirement account. It is also important to consider the difference in value between a pre-tax (and subject to penalty) retirement assets and after-tax cash.
Understanding the Tax Consequences of Divorce in Your Situation
At the Law Office of Shelly M. Ingram, our divorce attorneys keep the long-term effects of our clients’ divorce decisions in mind. While we are not tax attorneys or accountants and we are unable to offer you specific tax advice, we will help you identify concerns that may trigger detrimental tax consequences, and help you negotiate a reasonable settlement or property award that takes the IRS implications into account. Contact us today to schedule a confidential office consultation.