Tax Consequences in Pending Divorce

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

The negotiation of divorce and property settlements can significantly affect taxes. Maximize joint after-tax cash by minimizing taxes; and then decide how to divide the cash. At times it may even be advantageous to shift all the tax burden to one spouse.

Consider the following tax factors in divorce plans:

1) Tax basis of property being divided.

2) Payment of medical expenses. These expenses usually should be paid by the lower earning spouse.

3) Numerous ways to handle the family home.

4) Filing of separate returns.

5) Use of the Head of Household tax rate/exemptions for children.

6) “Kiddie Tax.”

7) Pension plan and IRA consequences.

8) Collection of overdue child support—it may affect tax refunds.

Property Settlements
No gain or loss is recognized on a transfer between spouses, or to a former spouse if incident to a divorce.

A property transfer is:

•“Incident to a divorce” if it (1) occurs within one year after the divorce, or (2) is related to the ending of the marriage.

•“Related to the ending of the marriage” if it (1) is made pursuant to a divorce or separation agreement, and (2) occurs within 6 years after the date on which the marriage ends becomes eligible for either the Hope or Lifetime Learning credit and his tax liability is $0.

• A transfer from a spouse to a third party that is made “on behalf of” a former spouse qualifies for Section 1041 treatment if:

1) Transfer to a third party is required by a divorce or separation instrument;

2) Transfer is at the written request of the former spouse; or

3) Transfer is made upon the written consent of the former spouse.

Note: Property acquired after the marriage ends qualifies for Section 1041 treatment if all other requirements are met.

Carryover Basis on Transferred Assets: The receiving spouse has a carryover basis (same tax basis as the transferor spouse) in the property. Carryover basis applies whether the adjusted basis of the property is less than, equal to, or greater than its FMV at the time of transfer. The receiving spouse also assumes the transferor spouse’s holding period.

Tax Planning: In a property settlement, the tax basis must be considered when dividing the assets. A spouse who receives a low basis asset should negotiate the appropriate offset factor to the asset’s fair market value.

Example: One spouse receives 100 shares in a publicly traded corporation worth $100,000 with zero basis. The other spouse receives their $100,000 savings account. FMV of each asset is equal. However, if the 100 shares are liquidated, the after-tax value is $80,000 after deducting 20% ($20,000) for federal tax. In this case, the offset factor would be the $20,000 tax. The spouse with the shares should get an additional $10,000 from the savings account in order that each spouse receives an equal share of $90,000.

Savings Bonds
If U.S. Savings Bonds are transferred incident to a divorce, the spouse transferring the bonds must include in income all interest earned on the bonds up to the date of transfer, but not previously reported. Interest earned after the date of the transfer is included in the income of the recipient. Basis of bonds received is increased by interest included in transferor’s income.

Deducting Cost of Getting a Divorce
Legal fees and court costs of getting a divorce are not deductible.

Nondeductible costs:

• Expenses paid in arranging child custody and support.

• Expenses paid in arriving at a financial settlement and retaining income-producing property.

Note: Legal fees paid specifically for property settlement are added to the property’s basis. Deductible (legal or accounting) costs: Fees paid for tax advice relating to a divorce.



Divorce—Joint Liability
Couples who file jointly are each individually and jointly responsible for any tax, interest, or penalty applicable to the return. This is true even if the divorce decree states that one spouse is responsible for

previously filed joint returns. Back taxes owed due to an audit are the responsibility of each spouse.

Consider Filing Separate Returns: Each spouse reports and pays tax on their separate income and deductions, and is liable only for their own tax return.

Divorce—Estimated Tax Payments
If a couple divorces after making joint estimated tax payments and later files separate returns, estimated tax payments may be allocated based on each spouse’s share of the current year’s tax liability; or claimed in full by one spouse; or claimed in part by each spouse.

Filing Status
There is a special tax rule known as the "abandoned spouse rule", whereby a separated parent with a child or children, can use the Head of Household filing status rather than the Married Filing Separate status. This option is available only if the parties did not cohabitate any part of the last six months of the tax year. The separated parent that does not have possession or custody of the child or children must file Married Filing Separate.