Divorce and income taxes – many times, these two issues become so intertwined that they become the “garden hose” of the negotiations, preventing settlement and paying for your attorney’s children’s education. If you were physically separated or divorced in 2013, there are several critical tax issues that you will need to address when filing your return in the next three weeks. These divorce tips will help minimize taxes or at the very least, enable you to adhere to the Internal Revenue Service Regulations for divorced or separated spouses.
Determining your filing status and how you will file your 2013 tax return is one of the most critical decisions that must be made. Below are the IRS rules for determination of that status. If you:
- Have lived apart for the last six months of the calendar year, you may qualify for Head of Household (HH) status; you could alternatively file as Married Filing Separate (MFS), or continue to file jointly
- Were divorced (as opposed to legally separated) by 12/31, you can file Single or HH (if you qualify)
With the tax filing deadline being April 15th, this decision on how to file can be critical if you are still in the negotiation stage. If you have been a stay-at-home Mom and your husband files your tax return electronically, your right to file as you want and possibly your only negotiating leverage will be taken away from you in one keystroke!
Electronic Filing of your tax return does not require the signatures of both spouses. All that is required is the Personal Identification Number (PIN) of each spouse that was provided when you first filed electronically. So if your spouse needs for you to file jointly (to save taxes), your opportunity to negotiate this point is lost. You will also be liable for any additional tax, interest, and penalty that may be assessed by the IRS in the future.
Hopefully, you had the advice of a CPA Divorce Specialist or CDFA™ prior to the preparation of the Separation and Divorce Agreement. In the absence of a formal agreement, if you are filing separate returns, you must agree on who will be taking the tax exemptions for the children or risk the IRS matching returns and triggering an audit or interest or penalties.
Which parent takes the dependency exemption should be 100% driven by the tax benefits of doing so. The greater a spouse’s Adjusted Gross Income (AGI) exceeds $150,000, the less tax benefit the spouse receives from claiming a child. You do not want to “leave money on the table” and pay more together than is required. On the other hand, physical custody sometimes controls who receives the tax benefits associated with a child. This includes the Child and Dependent Care Credit and HH filing status. Education Credits and the tuition expense deduction are controlled by who claims the dependent exemption but the Education Credits are limited by the parent’s AGI. Any one of these credits or deductions can result in substantial tax benefits.
What about mortgage and interest deductions?
Generally, if spouses file separately, then each is eligible to deduct the mortgage interest and taxes they actually paid. Absent an agreement stipulating otherwise, the source of the funds used to pay the mortgage dictates who is entitled to the deduction. Payments from a joint account are presumed to be made by each spouse, 50/50; payments from a spouse’s separate account are presumed to have been made by that spouse.
What about Use and Possession? Suppose Mom, with two children, is staying in the jointly-owned home and Dad is required to make the mortgage payments?
IRS regulations permit the personal use by any family member to inure to another family member when determining whether the house qualifies as a residence. In this situation, since the spouse’s children live in the house, Dad would be entitled to the interest and tax deduction. If there were no children, Dad could not deduct those expenses.
Alternatively, if Dad made the mortgage payment directly and the agreement identifies this payment as alimony, Dad could claim half the mortgage payment as deductible alimony and take a deduction for one-half of the interest and taxes.
What about payments made after the divorce? Where there’s a transfer of interest in the family home and the nonresident spouse is required to make payments associated with the home, the paying spouse may be able to deduct the payments as alimony. This is where divorce financial planning is a must. The deductibility requirements for alimony must be met and the resident spouse has taxable income. This income, however, can be offset by the itemized deductions for mortgage interest and taxes.
Alimony payments are deductible by the payor and taxable to the payee as long as the payments meet the IRS criteria. A problem arises where alimony is inadvertently or intentionally transformed into deferred property settlement proceeds.
Occasionally when the payer of alimony gets wind of tax benefits of alimony, he or she may want to “front-load” the payments, i.e. pay a significant amount in the first year or two. What this amounts to is converting a tax-free property transfer into tax deductible payment by the payor of the alimony.
The IRS wised up to this years ago and enacted rules to prevent excess front loading of alimony payments. Alimony payments that decrease or stop during the first three years may be subject to the recapture rule. If there is no decrease in alimony in excess of $15,000 in year two or year three following the year of divorce, the recapture rule will not apply.
So what happens if there is recapture? In the third year the amount to be recaptured is added back (taxed) to the payer’s income and subtracted (deducted) from the payee’s income.
In addition to the $15,000 limitation, there are other exceptions to the rule:
- If either spouse dies, or if the spouse entitled to the alimony payments remarries prior to the end of the third post-separation year
- The amount of payments fluctuates for reasons beyond control of the payer (e.g. payer pays a fixed percentage of income)
- The payments are temporary support payments (prior to filing for divorce)
The key to avoiding this dilemma is proper pre-divorce planning and having a CDFA™ run the calculation prior to signing a settlement agreement.
Email or call John today at 410-988-7333 for an initial, flat-fee consultation or a quote to provide the services that can put you on the right path to a positive outcome in your divorce.