While divorce can be a challenging experience personally, emotionally and practically, the financial effects are some of the longest-lasting changes. Not only do you need to manage asset division and the resulting change to both parties’ finances, but you may also find it challenging to adjust to budgeting for a single life, including changes to your lifestyle. One of the most significant concerns is often little-discussed: the tax implications of your divorce.
A divorce can be expensive. Not only do you need to account for the changes in your retirement funds and other assets, but you may need to review your budget to prepare for your financial future. This is in addition to the costs of the divorce itself, such as court costs and fees for your family law attorney and other professional services like therapists, financial planners and expert witnesses.
By planning in advance, you can mitigate the tax impacts of your divorce and avoid mistakes that could come with a hefty tax bill.
A recent change in the tax laws has altered the way that alimony payments are handled as part of your income taxes. Alimony is awarded to one party based on the consideration of many statutory factors. Not all divorces include alimony, but those where there is a disparity in income are more likely to include a support award as part of the final marital settlement agreement and divorce decree. You may work with your divorce lawyer to determine whether alimony will be part of the settlement.
Before 2017, payments for alimony were tax-deductible for the payer, which meant that many people agreed to a more generous spousal support agreement due to the positive tax benefits. When the 2017 Tax Cuts and Jobs Act was signed into law, this tax policy changed for divorces concluded in 2019 and thereafter. Now, payments for alimony are no longer considered deductible for the payer for federal tax purposes, they are also not taxable income for the recipient for federal tax purposes.
This change means that the altered tax status is likely to be built into alimony agreements. If your divorce is likely to involve spousal support, consult with your divorce attorney about what proposals can provide the greatest protection for your funds without exposing you to an unfair and unexpectedly high tax burden. You may seek a different type of settlement in order to mitigate the tax consequences of this change to the alimony law. Your divorce lawyer will likely also retain a tax expert.
When you conclude your divorce settlement, you and your spouse may need to transfer property. Real estate, vehicles or bank accounts may need to be transferred and retitled as the overall marital estate is divided between both parties. While the asset division process itself may take a significant amount of time in the negotiations to reach a settlement, it is important to prepare to execute the agreement well and avoid unexpected tax consequences. Family law attorneys can include tax issues as an explicit part of the negotiations and later settlement.
The transfer of property is generally not taxable when it takes place “incident to the divorce” due to a marital settlement agreement. Legally, the IRS considers transfers that take place within one year of the end of the marriage to be related to the divorce. However, that period can stretch to six years after the divorce decree, so long as the transfer is explicitly included as part of the settlement.
If the transfer takes place after one year but less than six years but is not included in the divorce decree, the IRS will generally consider it to be taxable. Regardless of the language of the settlement, most transfers that take place over six years after a finalized divorce will be treated as taxable.
There may be special concerns to keep in mind when large assets like real estate are transferred as part of a divorce settlement. Capital gains taxes are assessed related to the tax basis, the value of an investment for tax purposes. If a piece of property is valued at roughly the same amount as when the couple purchased it, this may not be much of a concern. However, if it has greatly appreciated, a simple transfer without a sale may leave the receiving party owing a significant amount in capital gains taxes if the property is sold, especially shortly following the divorce.
As a result, some couples may want to transfer the home through a sale to a third party. In addition, since the marital exemption for this type of a transaction is larger than that of a single person, the couple may prefer to sell the home as a married couple rather than doing so after the divorce, dividing the proceeds according to the settlement agreement. Both parties can work with their family lawyers and tax preparers to negotiate a settlement that addresses their unique tax concerns.
In addition to property transfers and spousal support, your divorce attorney can advise you about other tax issues that can come with your divorce. In the first place, your tax status is likely to change. Once the divorce is final, you will no longer be able to choose to file as married or file a joint return. This may mean that your tax bracket may change, especially if one spouse was a stay-at-home parent while the other worked full time. Your combined incomes may have put you in a lower tax bracket for married couples than the working spouse will face as a single person.
Further, some credits and deductions require you to earn less than a specific amount of income each year in order to access them. In most cases, single people have a lower eligibility threshold than married couples; at the same time, it may be easier for single people to lose their eligibility.
Parents will need to work with their family lawyers to determine how child tax credits are distributed between the parents, especially when both parents share joint custody of the children. Before the divorce, these credits were typically claimed on the joint return, but only one of the two parents may claim the credit. The parents may officially agree on who will claim the credit and how as part of their divorce settlement; some may choose to alternate while others may select one parent based on their respective taxable incomes.
If you are dividing a retirement plan as part of your divorce settlement, you may need a special court order called a Qualified Domestic Relations Order (QDRO), prepared by your divorce attorney for approval by the court. This document allows the two parties to transfer funds from one retirement account to another or to distribute a benefit to the other spouse. There may be taxes assessed for a distribution, although a transfer to another retirement account is typically untaxed. However, if the transfer is carried out without a QDRO, both parties may be saddled with avoidable extra tax penalties.
In all cases, please remember that receiving your final decree of divorce does not end your tax liabilities associated with the divorce. Your returns could be randomly audited up to three years after the divorce, with that period extended to seven years if the IRS argues that it has a good cause for an audit. Some couples may want to negotiate a specific provision in their divorce decree that addresses the handling of tax penalties or unexpected taxes after the divorce, including dividing potential costs associated with additional taxes or audits.
Taxes are one part of the financial concerns that can accompany divorce, and your family law attorney can advise you about the impact on you. Contact the experienced New Jersey divorce lawyers at Lawrence Law by calling 908-645-1000 or using our convenient, easy online form for a consultation at our Red Bank or Watchung offices.
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