Tax season is almost upon us, and if you’re separated or in the process of getting divorced, you may be concerned about how your relationship change will affect filing your income taxes. Do you still file as a married couple if you split up in 2014? Will selling your house this year as part of your divorce drive up how much you owe Uncle Sam next year? What about alimony payments? Here are four tips for dealing with common divorce-related tax issues.
Know Your Filing Status: Federal law states that every individual must file according to his or her marital status as of December 31st in any given year. This means that if you are separated or in the process of filing for divorce come New Year’s Eve, you still retain your marital filing status for that year — with the option of filing “married filing jointly” or “married filing separately.”
Which one is best? If you are relatively good terms (good enough to be able to cooperate on providing documents for tax filing), a joint filing status may still be appropriate. Some couples put in place an agreement for how that year’s final joint filing refund or tax amount owed will be handled. However, if there are concerns about income, such as a question about whether or not one party is reporting all income or withholding cash received in an effort to defraud the government or hide divorce assets, you might consider filing separately as a way to help establish immunity from any wrongdoings on the part of your spouse.
Use Your Divorce to Aid in Tax Planning: As you go through the process of divorce, understand that each term you agree to may come with a future tax implication, especially when it comes to marital asset division. Some settlement terms that might impact taxes include:
– If one party is buying out the other’s equity in the marital home, normally the person retaining the asset will be entitled to the deduction (such as a mortgage or property tax deduction).
– If the marital home is to be sold and profits shared between spouses, prepare to pay a possible capital gains tax the following year. Some spouses work out how much this will be and split other assets in their divorce to cover the amount that will be owed.
– If one party will be liquidating an IRA or 401k, they will have to pay taxes on this income, unless the taxes were already paid as would be in the case for a Roth IRA or a Roth 401K. Keep in mind that dividing such an asset in divorce does not necessarily create any tax impact; it is the liquidation that creates the liability. If you utilize a Qualified Domestic Relations Order (QDRO) to divide a retirement account incident to a divorce, tax implications may be avoided unless liquidation ultimately occurs.
Understand Tax Implications of Alimony: Spousal support is normally taxable to the payee, the person receiving the payment, and deductible to the payor, the person paying the alimony. What is most important for divorcing couples to keep in mind is that federal tax treatment of alimony is governed by the Internal Revenue Code, not by divorce agreements or court orders. However, your divorce agreement should state whether or not the parties agree that alimony payments are tax-deductible to the payor and taxable income to the recipient. (Parties can agree otherwise, which is most common in military divorces where not all income is taxable.)
In general, each alimony arrangement has its own specific tax implications. For example, if one spouse negotiates a high monthly payment award from the other spouse in lieu of obtaining certain assets, this higher alimony amount could push the receiving spouse into a higher tax bracket at income tax time. It can sometimes be helpful to take a look at the next year’s taxes (when you will be filing individually) to see how this will affect you. If the tax burden seems like it will be too much, renegotiations for a lower monthly amount and greater share of assets, or a lump sum alimony payment, may be more appropriate. Your attorney can help you with this, or refer you to a tax accountant or divorce financial planner if needed.
Keep Track of Divorce Tax Help – It May Be Deductible: Although you cannot deduct the cost of your divorce attorney and other expenses directly related to your divorce, you may be able to deduct legal fees paid for tax advice in connection with a divorce and legal fees to get alimony, up to 2 percent. In addition, you may be able to deduct fees you pay to appraisers, actuaries, and accountants for services in determining your correct tax or in helping to get alimony. To take this deduction, the IRS advises divorced taxpayers to obtain itemized lists of billable time with their divorce lawyers as a way to prove, if necessary, how much time and money was spent working on tax issues.
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