Handling divorce and everything that concerns the situation is never easy, so the tax implication will likely be the last thing on your mind. Divorce affects a person emotionally, physically, and mentally, and the tax system's structure gives no gap for quick decisions. However, neglecting tax issues such as child support or property division may affect your finances. In addition, divorce makes paying monthly bills and meetings complicated, and the hardship increases as tax obligations come to play. Well, then, here are some things you can expect with a divorce.
As of 2018, the law of alimony has changed. The new law does not allow a deduction from alimony or separation payments. This is because the charges are not included in the gross income of the spouse receiving them, and there is no deduction from who's paying.
Generally, four criteria qualify a parent to claim the kids as a dependent, and one states that a parent is entitled to the children if they have lived together for half a year. But if both parents have 50% time with the child, then the parent with the higher adjusted gross income (AGI) stands more ground. However, the parent in custody of the child can allow the other parent to claim the dependent through a process called releasing the dependent exemption. The process is filed through Form 8332, which you can submit with your tax returns. If you eventually release the child to the other partner, ensure you follow the rules; otherwise, the situation will force the IRS to get involved.
Generally, if divorcees sell their residence due to divorce or separation, they can escape tax penalties of up to 500,000 dollars if they have owned and stayed in the home for more than two years in the last five years. But if one partner leaves the house while the other remains, they can still prevent tax charges up to 250,000 dollars each when the home is sold. But this process will require extra documentation in the divorce decree or separation agreement to enjoy the tax exemption. However, if the partners do not meet the two-year ownership and use requirement, then the profit made from the sales is subject to tax for unforeseen circumstances.
The transfer of retirement funds is tax-free, but the distribution of retirement funds attracts tax. Likewise, withdrawals made from the retirement account may attract taxes. Therefore, you will need to hire a qualified domestic relations order agent (QDRO) if you intend to split a retirement account (401(k)) or a pension account. The QDRO is an order from the court giving a complete claim to an employer to own a retirement plan and the right to transfer some or all the funds to another payee or spouse. The plan administrator divides the retirement plan, and the process is done according to certain requirements. The procedures and criteria are listed in the QDRO.
The IRS treats the benefits as the recipient's retirement plan if you receive retirement benefits from the other spouse during divorce or separation. Therefore, the recipient can transfer the benefits from one retirement plan to another without paying taxes. The rollover is considered as the spouse's IRA on the transfer date.
During the divorce, some business interests are transferred, and a spouse should be careful to remit any income with tax attributes. For example, S corporation interest can lead to suspended losses. These losses may affect the future years if they are not deducted during the current year. Likewise, shifting interest from one person to another may lead to forfeiting suspended losses. As for a partnership interest, many complex matters may arise, such as share of partnership debt, built-in gains on joint property, capital accounts, and other complex issues.
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Jim McClaflin, EA, NTPI Fellow, CTRC