Divorce and Taxes – Tax Consequences and Effective Financial Planning
When getting a divorce, taxes are not usually a main concern. Yet, divorce may have a substantial impact on your overall financial situation. Knowing how taxes effect your divorce is important in preventing unnecessary added tax costs to a marital settlement, maximizing your property award, and avoiding post-divorce financial pitfalls.
Filing Status before the Divorce is Final
A spouse’s marital status for tax filing status purposes is generally determined at the end of the year. If still married on December 31, the couple can file a joint income tax return or each spouse can file a separate (married) income tax return. A spouse may also file as head of household if the couple separated prior to July 1 and continues to live apart at year’s end, the divorce (or decree of legal separation) has not been entered by the end of the year, and for the last six months of the year the parent has paid more than half the cost of maintaining the household that was the main home of the dependent. For tax filing status post-divorce, See Tax Issues After a Washington State Divorce.
How to File Taxes Before the Divorce is Final
Since Washington State is a community property state, the general rule is a couple filing separate returns for the year must report community income and deductions equally. If a couple separates during the year, and file separate returns, they must report one-half of the community income and deductions for the period prior to the separation date. This means separated spouses often must exchange W-2 and year to date pay stub information which each other to properly file their tax returns for the year of separation. This can become complicated – especially in high asset divorces; for example, if there is dispute over whether a real property with rental income is separate or community, who pays tax on the income may need to be determined as part of the divorce settlement.
Sale of a Home in Divorce
What happens if you sell your home during or after a divorce? If a house is to be sold due to divorce, there are several things to keep in mind. If the home is sold before divorce, you and your spouse file a joint return, and have used it as your primary residential home for two of the previous five years, the general rule is you will be able to exclude up to $500.000 of profit (gain) from capital gain taxes. Each spouse has an individual exclusion of $250,00 of gain. If a divorce couple does not meet the eligibility tests qualifying them for full exclusion, they may still be able to claim partial exclusion. If a home is awarded to one spouse in a divorce, and then sold, the spouse may exclude $250,000 from capital gain taxes.
Key Tip: If a divorce has started, and sale of the home is anticipated, a properly negotiated divorce settlement will address sale of the home, joint tax filing issues, timing of the transfer of title, and personal resident requirements, to make sure the full $500,000 is excluded.
See IRS Publication 523
Alimony and Spousal Payments(Maintenance)
Alimony or spousal maintenance payments were once tax deductible to the payer spouse and included as gross income to recipient spouse. That changed under 2017 Tax Cuts and Jobs Act. As of January1, 2019, alimony is no longer tax deductible to the payor or reported as income to the receiving spouse. Alimony is now treated like child support payments for tax purposes.
Property Transfers in Divorce are Generally Not Taxed
Transfers of property between spouses based on a divorce, legal separation, or separation agreement are generally not taxable events, so no gain or loss is reported. For example a husband’s transfer of his property interest in the marital residence to his wife as part of a divorce settlement is not reportable as capital gain or loss to the recipient spouse. A QDRO (qualified domestic relations order) is a special court order that allows retirement account assets to be transferred tax-free in a divorce.
Who Gets the Child Tax Credit in Divorce
The federal tax code, by default, allows the parent with custody of a child for the majority of the calendar year to get the child tax credit for that child. However, the tax code allows the custodial parent to waive that right so the non-custodial parent can use it if they sign IRS Form 8332. In 2021, the child tax credit was raised to $3,600 for children younger than 6 and $3,000 for children age 6 to 17.
Washington courts awards the child tax credit based on a number of factors including which parent provides the majority of the child’s support and the degree of economic benefit each party would obtain from the credit.
Financial Planning in Divorce – Avoiding Financial Disaster
Careful review of the long-term financial consequences of a divorce settlement is essential.
Although obtaining a certified divorce financial analyst is often advisable for high asset complex divorces, at Weintraub Law Office, we can help prepare and analyze much of the basic financial planning work such as valuing assets and liabilities, developing realistic budgets, estimating spousal maintenance needs, comparing after-tax proposed settlements, and developing alternate settlement proposals.
Settlements that appear fair on the surface do not always take into account the long term economic consequences associated with post-divorce spouses relying on their individual finances to maintain separate households, particularly where when there is a substantial disparity in current and prospective earnings and children involved.
Example: The Smaller Earner Takes the Big House Scenario
A typical problem scenario is when a lower income earning spouse takes over a large home and associated high mortgage so the children can continue to reside in it. The “breadwinner” has moved out and is living in an inexpensive rental.
While the spouse may have equity in the home, it is tied up in the house and may not be accessible unless she sold it at potentially great cost (i.e., after incurring costs of improvement to prepare for sale, real estate commissioner fees, and excise taxes). Even if the spouse is awarded a retirement plan, severe tax penalties occur for early withdrawal. The result is that the spouse may end up needing to sell the home with little or no savings left. The “breadwinner” spouse, however, has managed to grow his savings appreciably as his earnings have improved. With careful financial planning and a well negotiated divorce settlement, such long-term consequences are avoidable.
The Innocent Spouse Rule and Divorce
A joint tax return imposes “joint and several” liability on spouses, so mistakes or intentional omissions by one spouse can leave the other fully liable for the underpaid tax. The IRS can collect against the “innocent spouse” unless that spouse can meet the requirements of the Innocent Spouse Rule. To pursue an “innocent spouse” claim, hiring a tax lawyer is advised.
Divorce lawyers often include hold harmless and indemnity clauses in settlement agreements and decrees to protect the “innocent spouse” against potential future harm. Such provisions allow the “innocent spouse” to obtain a judgment for reimbursement. The only way to prevent collection, however, is by meeting the requirements of the rule.
Tax Consequences of Equity Compensation Plans in High Asset Divorce
Tax consequences of equity compensation plans, and addressing the mechanics by which spouses are to exercise stock compensation awards post-divorce, are complicated matters that require an experienced divorce lawyer. The following information provides a summary comparison of such plans and their tax consequences.
Employee Stock Options
Stock options give employees the right to buy the company’s shares at a price fixed at date of grant for a specified number of years. Employees must meet certain vesting requirements, such as continuation of service and/or meeting of performance goals, before the right can be exercised. There are two types of stock options with different tax consequences:
- Nonqualified Stock Options (NSO). Nonqualified stock options allow an employee to purchase the employer’s shares at an amount determined by the grant price. Once vesting requirements have been met, the employee may “exercise” the stock option by purchasing the stock at the grant price. The difference between the grant price and the fair market value of the shares on the date the option is exercised (i.e., exercise or strike price) is the “spread”. The “spread” is taxed as ordinary income or loss at the employee’s tax bracket and included in the individual’s W-2 even if the shares are not yet sold. However, if the employee does not sell the stock upon exercise of the option but does so at a later time, any difference between the fair market value on the date of exercise and the sale price is reported as a capital gain or loss.
- Incentive Stock Options (ISO). Incentive stock options qualify for special tax treatment. Subject to certain holding period and other requirements, an ISO allows an employee to defer taxation from the date of exercise to the date of sale of the underlying shares. When sold, the difference between the grant price and the proceeds from sale of shares is taxed as capital gain or loss.
Employee Stock Purchase Plans (ESSP)
These plans allow employees of a corporation to purchase the corporation’s stock, usually at a discount (typically 10%-15%), at the end of an offering period. Employees contribute to the plan through payroll deductions which increase during the offering period. On date of purchase, the company uses the accumulated funds to buy company shares on behalf of the employee. Employees are not taxed until they sell the stock. Upon the employee’s sale of shares, the difference between the share value at the beginning of the offering period and the discounted price (or the actual profit on sale if less) is taxed as ordinary income, and any other gain or loss is taxed as capital gain or loss.
Restricted Stock Units (RSU’s)
Restricted stock plans generally give employees the right to obtain and purchase shares at cost, discount, or no cost, depending on the plan, only after vesting requirements are met. The shares of stock are restricted from being delivered until vesting and forfeiture requirements are satisfied. The difference between the grant price of the stock and the fair market value of the stock as of the date of vesting is taxed as ordinary income. However, if the employee does not sell the stock at vesting and sells it at a later time, any difference between the fair market value on the date of vesting and the sale price is reported as a capital gain or loss.
Bo Weintraub, a graduate of the University of Washington School Of Law’s Masters in Tax Program, is uniquely qualified to handle the complicated tax aspects of divorce.