Tax Issues on Divorce

Tax Issues on Divorce

With income tax deadlines looming, many people have questions concerning how a divorce will affect the filing of taxes in the year the divorce is granted and future years.

As a general rule your status for tax filing purposes is based on your marital status on December 31 of the tax year. Therefore if you are divorced on December 30, 2001, you would not file a joint return or married filing separate for 2001 if you follow Internal Revenue Service rules and regulations. Under this scenario a separate return is filed.

The following are common questions that arise as a result of a divorce:

Who is allowed to claim the dependency exemption for children?

Section 152(e) of the Internal Revenue Code allows the custodial parent to claim the child or children as dependents if the child receives over one-half of his or her support from both parents; is in the custody of one or both parents for more than half of the calendar year; and the parents are divorced or legally separated under a divorce decree.

This provision is a legal presumption that the custodial parent should claim the dependency exemption. Under Tax Regulations Section 1.152-4 “custody” will be determined by the terms of the Divorce Decree.

Please note that other sections of the IRS Code may govern your ability to claim an exemption. For example, your exemption will phase out at certain income levels.

If my divorce decree provides for the claiming of a tax exemption how does that impact my rights under the Internal Revenue Code?

Often times, people will negotiate the tax exemption of children as part of their divorce. This is more common with Joint Managing Conservatorship in Texas. However, negotiating the tax exemption does not always make sense. Texas case law has held that a State Court is preempted from entering Orders relative to tax issues due to the fact that Federal Law establishes how taxes will be filed. This is called federal preemption. A party may by agreement include procedures for filing taxes within their divorce decree. The effect is to create a contractual relationship between you and your former spouse on that issue. Therefore, if you agree to give up the tax dependency exemption, your decree will typically provide a requirement to execute IRS forms which waive the exemption or grant the exemption to your spouse. If you refuse to follow the decree because you are entitled to the exemption under the IRS code, you will be in compliance with federal law, but you may have bought a breach of contract lawsuit from your ex spouse.

Do I have to pay taxes on property transferred to me in my Divorce?

NO.Section 1041 of the Internal Revenue Code provides that no gain or loss shall be recognized on the transfer of property from an individual to a spouse or former spouse pursuant to a divorce. The effect of this is that the property received will have the same tax basis as it had when acquired and not the fair market value at the time of the transfer. Therefore, in the case of an IRA rollover or transfer of 401k benefit, the receiving spouse will pay capital gains taxes if they subsequently liquidate part of the asset after the transfer based on the assets original basis. If the asset is liquidated prior to divorce and the transfer is cash, the spouse who liquidated the asset (transferring spouse) will be liable for the capital gain realized, and the cash will transfer tax free.

What is the Community Tax Split, and can I avoid it?

In the year of the divorce, parties are generally required to include on their separate tax return one half of all community pre-divorce income and deductions, and one hundred percent of all post-divorce income and deductions of the filing ex-spouse on their respective returns. In addition the filing ex-spouse will claim 50% of pre-divorce federal withholding and estimated tax payments and all pre-divorce separate income. This is commonly referred to as the Community Tax Split.

The allocation of community income prior to divorce may be modified under certain circumstances. Section 66(a) of the Internal Revenue Code allows a party to avoid the community tax split if the parties have lived separate and apart for the entire year (pre-divorce period and post-divorce period), and no portion of community income has been transferred between the spouses during the calendar year. Under this scenario you would be allowed to claim one hundred percent of your income and deductions for the year and claim one hundred percent of estimated tax payments and federal withholding for the year without allocating any portion to your ex spouse or claiming any portion of your ex-spouses income or deductions on your return.

These are a few issues that arise concerning federal income tax filing in a year where parties are divorced. Due to the complexity of tax laws and changes that occur, you should consult with a CPA in addition to your attorney to determine which provisions will apply to your situation. You should also keep in mind that most divorce decrees will not prevent parties from filing tax returns in a form that is most advantageous to their situation. When it comes to taxes, even in a divorce it is always beneficial if both parties can agree to maximize their rights under the Internal Revenue Code.

In my next article, I will discuss the procedure of filing for and obtaining a divorce in Texas. Any questions or comments may be emailed to me at brian@loughmiller-law.com.

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