Okay, hang on! This material on tax in divorce is technical. You can get lost in it. Don't. Just look for the pieces that are relevant to you and hone in on them. Ignore the stuff that doesn't apply to you and your spouse.
There are some decisions you and your spouse can make in divorce that will cut down on taxes. The savings for one of you may be enough to be worth doing, even though they may work to the disadvantage of the other spouse. If you're able to stay in control and cooperate with your spouse, though, you can make decisions together that will work well for both of you.
The one who enjoys a tax advantage simply needs to compensate the other spouse for the burden he or she is assuming. You can both be better off. Trust me. You'll be proud later to tell your friends how you worked together to save on taxes.
Note: this is an HTML version of a paper on taxes in divorce. You'll quickly notice two things:
Here are the main categories for the information on this page:
Before 1984, the characterization of a transfer between divorcing spouses followed the so-called Davis rule. The Davis rule looked primarily to state law. If state law indicated that the spouse receiving property already owned an interest in it before the transfer, the transfer would be characterized as nontaxable. On the other hand, if state law indicated that the receiving spouse did not have an interest in the property before the transfer, the transferring spouse would be required to include any gain realized in gross income.
Davis and its progeny produced a confusing array of inconsistent results, depending on whether the state was a community property state, an equitable distribution state, or a simple common law state. Congress enacted §1041 in 1984 to simplify and clarify the treatment of transfers between spouses incident to a divorce.
§1041 provides that neither the transferor nor the transferee are to recognize gain or loss on a transfer of property to a spouse or, if the transfer is incident to a divorce, to a former spouse. If the transfer meets the §1041 test, it will be treated as a nontaxable event, and the basis will follow the asset. That is, the transferee spouse will take a carryover basis in the transferred property (equal to the transferor's adjusted basis). The effect of this basis transfer is to shift to the recipient spouse any tax liability for appreciation of the asset.
§1041 treatment is mandatory. There is no opt-out provision analogous to I.R.C. §71(b)(1)(B), which allows spouses to elect non-alimony treatment for payments that otherwise would constitute alimony.
To fall under §1041, a transfer must either (1) occur within one year after the marriage ceases, or (2) be "related to the cessation of the marriage." The Service construes the first qualification liberally, the second more narrowly.
The Regulations say this applies even to property acquired after the marriage ceases, and that a transfer occurring within one year after the marriage ceases need not have any connection with the divorce.
A transfer will meet this standard only if it is both pursuant to a divorce or separation agreement and occurring within six years after the marriage ceases.
A transfer to a third party on behalf of the spouse or former spouse can qualify for §1041 treatment, provided it meets one of three tests:
The rules related to a qualified retirement plan generally provide that the benefits under the plan may not be assigned, alienated, garnished, attached, or pledged as collateral for a loan. There are several exceptions to this principle, the best-known and most significant of which deals with Qualified Domestic Relations Orders (QDRO's).
The Code defines a "Domestic Relations Order" as any judgment, decree, or order (including approval of a property settlement agreement) that (a) relates to the provision of child support, alimony, or marital property rights to a spouse, former spouse, child, or other dependent of the participant, and (b) is made under a state domestic relations law.
A "Qualified Domestic Relations Order" is a Domestic Relations Order that recognizes or creates a right of an alternate payee to enjoy all or a portion of a participant's interest in a qualified retirement plan, so long as it does not alter the amount or form of the participant's benefit, and so long as it states the following facts:
To the extent provided in the QDRO, the plan will treat the former spouse of a participant as the participant's surviving spouse as it relates to the requirement to pay a surviving spouse a joint and survivor annuity or preretirement survivor annuity.
The marital home, along with retirement plan interests, is often among the most valuable assets to be disposed of in a divorce. Typically, one spouse conveys his or her interest in the home to the other spouse, who may own the home for months or years before selling it.
The transfer of an interest in the home from one spouse to another in a divorce qualifies as a §1041 tax-free exchange. The transferee spouse takes a basis in the home equal to the basis held previously by the transferor and transferee together.
When the transferee spouse sells the home, Code §1001 provides that, in the absence of any exception, the transferee spouse will owe tax for the year of the sale on the difference between the amount realized from the sale and the transferee spouse's adjusted basis
Fortunately for divorcing taxpayers (and homeowners in general), there is a significant and helpful exception in the form of revised Code §121. For any sale of a personal residence on or after May 7, 1997, a taxpayer may exclude up to $250,000 of the gain on the sale. A married couple may exclude up to $500,000. The taxpayer must have lived in the residence for two of the five years before the sale. A taxpayer (or married couple) may use this exclusion as often as once every two years.
Two other rules make this provision doubly appealing to divorcing spouses. First, a taxpayer whose spouse is living in the house pursuant to a divorce or separation may include the other spouse's residence period as his own. Consequently, a couple could divorce and agree for the wife to move out, retaining her ownership of the house but giving up all rights of possession. The husband could remain in the house for years. When the house is sold (provided Congress hasn't changed the law in the meantime), the wife could include the husband's time of residence as her own and exclude $250,000 exclusion from her share of the gain.
Similarly, a divorcing spouse who hasn't owned the house for a full two years may use the former spouse's period of ownership as her own for purposes of meeting the two year requirement. So if
The first exception to this rule is Code §1034, the so called rollover rule. If a taxpayer sells his principal residence and, within two years before or after the sale (the "2+2 period"), purchases another residence and uses it as his personal residence, the taxpayer will recognize gain only to the extent that the adjusted sales price of the old residence is more than the cost of the new residence.
The personal residence can be a condominium, or even a houseboat or house trailer. It cannot be personal property such as furniture or other items that are not fixtures under applicable local law. The taxpayer must have a legal interest in the property. There can be only one principal residence, but it can be sold in a series of transactions.
The adjusted sales price is the consideration received from the sale (including assumption of debt) reduced by the costs of sale, such as sales commission, advertising costs, legal expenses, and certain fix-up expenses.
This includes the cost of acquisition, construction, reconstruction, and any improvements made within the 2+2 period.
The taxpayer's basis in the new residence will be the cost reduced by any gain not recognized (rolled over) on the old residence.
Courts and the IRS have construed the 2+2 period technically and narrowly. It doesn't matter that the taxpayer made a good faith effort to occupy a new residence. Nor does it matter that the FHA stopped insuring mortgages or that the new house was destroyed by fire. There is a special provision allowing up to a 2+4 period, however, for members of the Armed Forces.
The taxpayer should file Form 2119 to show the details of the sale of his old home and, if applicable, the purchase of the new one. If a taxpayer gets divorced after filing a joint return on which he postponed reporting tax on the gain on the sale of his home, but he doesn't use his share of the proceeds to buy or build a new home (and his former spouse does), he must file an amended joint return to report the tax on his share of the gain. If his former spouse refuses to sign the amended joint return, he should attach a letter telling why his former spouse will not sign it.
Subject to some ownership and occupancy tests, a taxpayer can exclude up to $125,000 ($62,500 for married persons who file separate returns) of the gain from the sale of his principal residence that occurs after he reaches the age of 55. This is a once-in-a-lifetime exclusion, not just a deferral.
The principal challenges facing divorcing couples involving the marital home all revolve around capital gains. There is much discussion currently about the treatment of capital gains on the sale of the principal residence, and Congress may opt to eliminate it entirely. Until that happens, it pays to be aware of some traps:
The rollover is available only if the house is the principal residence of the taxpayer at the time of the sale. One spouse will frequently move out and live in other quarters for a period of months or even years before the house is sold, and then attempt to trade up in a tax-free rollover and avoid tax on his or her share of the gain. This won't work.
The two spouses will be treated differently. The spouse who lives in the house will be entitled to tax-free rollover treatment (if he or she can afford to trade up). The spouse who has moved out and established another residence will be required to recognize gain on what has become a personal asset held for investment purposes.
The first solution is for the spouse who is moving out to go ahead and quitclaim to the remaining spouse his or her share of the house. That leaves the remaining spouse fully responsible for the tax ramifications of the sale and releases the vacating spouse from any tax ramifications.
Alternatively, it is possible to maintain for some reasonable time that the house remains the principal residence of the vacating spouse, even while the vacating spouse is actually living elsewhere on a temporary basis. I don't encourage my clients to try this, but if they're determined to try it, I encourage them to take as many of the following steps as practicable:
Often the parties have bought and sold houses several times during their marriage, each time trading up and deferring the tax by using a tax-free rollover. They have been able to enjoy a lifestyle fueled in part by cash borrowed on the house. Their present house may have a value of $300,000, with a mortgage of $240,000, and they may have a basis in the house of $50,000.
They both believe they have an equity in their house of $60,000. They're both wrong. Their actual after-tax equity is much less:
| Value | 300,000 | |
| Less 7% real estate commission | 21,000 | |
| Net proceeds from sale | 279,000 | |
| Mortgage balance | 240,000 | |
| Actual before-tax equity | 39,000 | |
| Basis in house | 50,000 | |
| Capital gain on sale (net proceeds less basis) | 229,000 | |
| Tax on capital gain at 28% plus 5% | 73,280 | |
| Functional equity | (34,280) |
In English, this couple thinks they have an asset with significant value, when the asset actually is a net liability.
It is not unusual for divorcing spouses to agree to split the proceeds from the sale of the house in some ratio other than 50/50. This is fine with Uncle Sam, but Uncle Sam will not be bound by the division to which they have agreed. As far as the Service is concerned, the parties were equal owners at the time of sale. Consequently, each is responsible for half the applicable tax. The planning challenge, then, falls to the spouse who agrees to accept less than half the proceeds yet is responsible for half the tax.
There's some possible good news about capital gains.
The payor spouse who makes payments to his spouse or children may not feel that he is making a voluntary gift, but the test to determine whether a gift has occurred doesn't look to his intent. The focus of the test is purely objective, that is, whether the transfer is for "less than an adequate consideration in money or money's worth." Consequently, quite a few of the payments made during and after divorce would, absent some exception, constitute gifts. Luckily, there are several exceptions.
Even if a transfer is for less than adequate consideration, it will be deemed to be supported by adequate consideration if it satisfies four requirements:
The parties' agreement to the payments must be a written agreement.
The payments must be required in the agreement.
The agreement must become effective within two years before or one year after an actual divorce is final. There is no requirement, however, that the agreement be incorporated into the divorce decree.
Only those payments in satisfaction of the marital support and marital property rights of a spouse and the support rights of a minor child qualify. Payments for other purposes, for example the support of an adult child, are not deemed to be for adequate consideration. The payments can be made, however, to a trust without affecting the qualification for the test.
Payments that do not qualify under the §2516 "deemed adequate consideration" test can nevertheless be treated as non-gifts if they are ordered by a court. The theory is that a gift must be a voluntary transfer, and a transfer ordered by a court is not voluntary. If the transfer is not voluntary, then, it is irrelevant whether it is supported by adequate consideration, even if it is for the support of an adult child.
The seminal case in this area is Harris v. Com. The court held in Harris that when a divorce court incorporated a settlement agreement between a husband and a wife into a divorce decree, it could have changed it. Consequently, the payments required by the agreement were not gifts because they were court-ordered. The IRS has attempted to restrict the effect of Harris, and courts have been supportive, but the essential principle remains.
Also, payments can be pursuant to a court order and receive non-gift treatment even though they would fail the §2516 test because an actual divorce never occurred.
Any married person has an obligation under state law to support his wife and minor children. Consequently, a payment to a spouse or minor child for support during marriage is not a gift, even if there is no consideration paid in return. The same principle applies after divorce to the extent the person still has obligations of support under state law.
Code §2503 specifically excludes from gift tax liability any direct payment of tuition costs or medical expenses of any individual. The exclusion is available regardless of family relationship or lack thereof and regardless of any legal responsibility or lack thereof. Consequently, it would apply to payment of expenses of an adult child, a stepchild, or even a friend.
The payment must be made directly to the provider, however. Payments cannot be made directly to the person benefited, either before or after such person pays the provider. Nor can they be made to a trust that pays them to the provider.
If an outright transfer occurs between spouses while they are still married, the transfer can be free of gift tax because it qualifies for the unlimited gift tax marital deduction. The key requirements here are that the transfer occur while the spouses are still married and that it not be a terminable interest. For example, if the transfer occurs after a divorce is final, it is not eligible for the marital deduction.
Also if a spouse receives only a life estate, with the remainder to a third party (for example, a child), the transfer will not qualify for the marital deduction unless the grantor spouse makes a QTIP election.
Alimony (or "Separate Maintenance") is included in the gross income of the payee spouse and deductible to the payor spouse. Child Support, on the other hand, is not. Child Support is specifically excluded from the definition of Alimony.
The tax treatment of continuing support introduces an unavoidable measure of tension between the payor spouse (who prefers that payments be characterized as deductible alimony) and the payee spouse (who prefers that the same payments be characterized as child support or property settlement so they need not be included in the payee spouse's income). The payment of the costs of housing, particularly as the payment relates to the cost of maintaining the marital home, also presents tax issues, property settlement issues, and alimony issues.
The terms "alimony" and "separate maintenance" are used interchangeably in the Internal Revenue Code, and characterization as alimony does not depend on state law. Alimony must have six characteristics:
A payment of cash by the payor spouse to a third party under the terms of the divorce or separation instrument can qualify as a payment "on behalf of a spouse." So can payments to a third party made at the request of the payee spouse.
Payment of life insurance premiums on the life of the payor spouse under a qualifying divorce instrument will constitute alimony to the extent that the payee spouse owns the policy.
Congress recognized the temptation to characterize property settlements as alimony, so the 1984 Tax Reform Act contains provisions calling for the recapture of "excess" alimony (that looks too much like a property settlement). Specifically, the rules provide that if alimony is excessively "front-loaded" (concentrated too much in the first two years of payments), the payor spouse must recapture it (include it in the payor spouse's gross income).
The Excess Alimony rules are limited in their effect to the first three years in which the payor spouse makes payments. The first measurement year is the calendar year in which alimony is first paid (called the 1st post-separation year). The second and third years are the immediately following calendar years (called the 2nd and 3rd post-separation years, respectively).
Only the excess alimony paid in the 1st and 2nd post-separation years is subject to recapture. There is no such thing as excess alimony paid in the 3rd post-separation year or subsequent years.
The calculation of the front-loading rules is a five-step process, working in reverse chronological order:
Here are the calculations of the front-loading rules, assuming payments in the 1st, 2nd, and 3rd post-separation years of $75,000, $60,000, and $40,000, respectively:
| 1st post- | 2nd post- | 3rd post- | ||
| sep year | sep year | sep year | Total | |
| Payments | 75,000 | 60,000 | 40,000 | 175,000 |
| Decrease in 3rd post-separation year | 20,000 | |||
| Permitted Decrease | 15,000 | |||
| 2nd post-separation year excess (Step 1) | 5,000 | |||
| 2nd post-separation year non-excess (Step 2) | 55,000 | |||
| Avg. of 3rd year & non-excess 2nd year (Step 3) | 47,500 | |||
| 1st year's payment less the average | 27,500 | |||
| Less $15,000 permitted decrease (Step 4) | 12,500 | |||
| 1st year excess payments | 12,500 | |||
| 2nd year excess payments | 5,000 | |||
| Total excess payments (Step 5) | 17,500 |
The front-loading rules do not apply to payments that change because of the death or remarriage of the payee spouse, or to payments that are calculated as a portion of the income from a business or property or from compensation for employment or self-employment. They also do not apply to temporary support payments pursuant to Code §71(b)(2)(C).
When the divorce decree or separation agreement identifies a specific amount of continuing support as child support, the amount so designated will not be treated as alimony. Payments can be characterized as child support even though they are for the support of an adult child. In addition to the specific designation of a child support amount, a payment will be treated as child support to the extent it is subject to reduction (1) on the occurrence of a specified contingency relating to the child, or (2) at a time that can clearly be associated with such a contingency.
The Regulations include the following contingencies: the child's attaining a specified age or income level, dying, marrying, leaving school, leaving the spouse's household, or gaining employment.
The statutory language in Code §71(c)(2)(B) could arguably be interpreted to mean that any reduction in alimony that might fall anywhere near any date of significance related to a child could be enough to change the tax treatment. The Regulations, however, break the issue down to two tests, both of which can be calculated with certainty.
The first test is simpler to explain and apply than the second. It concerns itself with whether any reduction in alimony comes within six months of the 18th or 21st birthday of a child, or in Alabama, the 19th birthday.
The second test cannot come into play unless there are at least two children and at least two dates on which reductions take place. It concerns itself with whether payments are to be reduced on two or more occasions that occur within a year before or after two or more children attain a particular age between 18 and 24 years. The measuring age must be the same for each child, but it need not be one of whole years.
If a reduction satisfies one or both of the tests, the payment will be rebuttably presumed to be child support to the extent the reduction coincides with the contingency related to the child. Rebutting the presumption requires a showing (either by the taxpayer or by the IRS) that the date of the reduction is set independently of a contingency related to a child.
Whenever one party is obligated in a divorce property settlement to make mortgage payments or to pay property taxes on a residence, the double considerations of mortgage interest and property tax become relevant, with alimony as an umbrella concept.
It is not unusual for one of the spouses to be required to make mortgage payments on the marital home even though he or she does not live in it. Mortgage interest must be paid with respect to a "qualified residence" to be deductible. Code §163(h)(5) states that a "qualified residence" must be either the principal residence or "1 other residence of the taxpayer which is . . . used by the taxpayer as a residence (within the meaning of section 280A(d)(1))." Section 280A(d)(1) says the taxpayer uses the dwelling as a residence if he uses it for 14 days within the year, or for 10 percent of the time it is rented, whichever is greater.
It is helpful that the taxpayer is deemed to have used the unit to the extent that he or "any member of the family of the taxpayer" uses it. So if the payor spouse's child or children live in the home, the requirement is probably satisfied. If not, it is doubtful whether an ex-wife constitutes "any member of the family." Note that even if the payment cannot be deducted as mortgage interest, it may be deductible as alimony.
Payments of mortgage principal are not deductible.
The person who pays state, local, or foreign real property taxes for which he or she is responsible is entitled to claim those payments as an itemized deduction. If the property is sold in the middle of the year, the tax shall be deemed to be apportioned between the seller and the purchaser and will be prorated based on the portion of the year during which each party owned the property. If one spouse pays property taxes owed by the other spouse (or former spouse), the payments may constitute alimony if properly structured.
Code §21(a) allows certain taxpayers to claim a tax credit equal to from 20% to 30% of certain employment-related dependent care expenses. In divorce, this credit is available only to the parent who has custody for a greater portion of the year.
Before the 1984 changes, the custodial parent was entitled to the exemption for each child unless the noncustodial parent satisfied specific annual support requirements. The protracted questions and inter-spousal conflict generated by this approach convinced Congress in 1984 to simplify the rules. In 1997, Congress tied the exemption to the $500 child credit, the Hope Scholarship, and the Lifetime Learning Credit, thus making it more valuable to taxpayers.
Tax law now provides that if a minor child lives with one or both parents for more than half the year and if the parents together provide more than one half the support for the child, the parent with whom the child spends more time is entitled to claim the exemption, even though the other parent may be providing more than half the child's financial support.
The rule does not apply where the custodial parent releases his or her claim to the exemption for the year using Form 8332.. It also does not apply if more than half of the support is deemed received under a multiple support agreement. And it does not apply if a pre-1985 divorce or separation agreement is in effect that has not been modified to apply the current statutory rules.
The value of the exemption to the taxpayer varies with the taxpayer's income. Click here for the value of the exemption (and the $500 child credit that now attaches to it) at various levels of income. Click here for the same information in graphic form.
Marital status is determined on the last day of the tax year (or on the date of death if one of the spouses dies during the year). The questions whether and when a divorce is effective are matters of state law.
Legal Separation. Persons who are legally separated under a decree of divorce or of separate maintenance are considered not to be married for tax purposes. Note, however, that a decree of support or temporary alimony alone is not considered a decree of divorce or separate maintenance for purposes of establishing a non-marital state, nor is a voluntary separation, even pursuant to a written separation agreement.
The "Abandoned Spouse" Rule. A person who is still formally married can nevertheless file as a single person if he or she meets the following requirements:
Common Law Marriages. If local law recognizes a common law marriage, so will the IRS. If a couple validly marries in a state that recognizes common law marriages, and then moves to a state that does not recognize common law marriages, their marriage remains valid even in the new state.
The marginal tax rates generally are lowest for married individuals filing jointly. They progressively increase for each category as follows: head of household; individual, married filing separately.
Married filing jointly. This produces the lowest tax rates and the highest standard deduction. Filing jointly makes it impossible to pay alimony, however, and it also introduces the specter of joint and several liability. Subject to the Innocent Spouse Rule, taxpayers filing a joint return are jointly and severally liable for any tax, penalties, and interest arising out of the return. An indemnity agreement in which one spouse holds the other harmless for tax deficiencies (or another similar undertaking) may be binding as between the husband and wife but is not binding on the IRS.
Head of Household. Persons filing Head of Household enjoy a tax rate lower than that for single taxpayers but higher than that for married persons filing jointly. To file as head of household, the taxpayer must be unmarried at the end of the year, must maintain as his or her home a household where a child lives for more than half the year, and must pay over half the expenses of maintaining the home.
Married Filing Separately. Married persons filing separately pay the highest tax rates. The main advantages of filing a separate return are to avoid joint and several liability and to enable deduction for alimony while the taxpayer is still married.
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