This publication explains how to avoid paying taxes on divorce settlement. You can tell how complex a divorce can be, plus having to pay taxes on the settlement.
You need a financial advisor when you face a divorce or are currently in the middle of it. You do not also always need a financial advisor when planning finances for a divorce. Besides, some factors allow you to avoid or at least reduce taxes on a divorce settlement.
It is equally advisable to understand how federal tax policy works on divorce.
How to avoid paying taxes on divorce settlement
Consider the following options if you want to avoid taxes on divorce settlement:
Focus on alimony and taxes
You could focus on alimony and taxes as a way to avoid paying taxes on a divorce settlement. Typically, the higher-earning spouse agrees to alimony payments in a divorce settlement.
Alimony payments are payments the higher-earning spouse makes over time, which is meant for the income gap between the divorcing spouses.
In some cases, a spouse may have to make alimony payments indefinitely, or until the recipient partner remarries.
Under IRS conditions, alimony payments count when:
- you did not file a joint return with your divorcing spouse;
- payment is made to/for your former spouse under a divorce;
- you are not a member of the same household as your spouse when the payment is made;
- payment is made in cash, money orders, or checks;
- the payment is not towards a property settlement or child support; and
- there is no payment liability after the recipient spouse dies.
Regarding if you are not a member of the same household when making the payment. This only applies if you are legally separated from a recipient spouse under a decree of divorce or of separate maintenance.
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In some cases, cash payments may include any payment to third parties, but you do not benefit from the alimony payments.
For instance, you could make alimony payments when you pay the mortgage on the house of your former spouse. This will not count as alimony if also continued to live in the house.
Alimony, according to the IRS, does not specifically include the following:
- noncash property settlement;
- child support;
- voluntary payment;
- Use of the payer’s property;
- payments made to keep the property of the payer; and
- your divorced spouse’s community property income payment.
If you established your divorce settlement on/before December 31, 2018, alimony payments are fully tax-deductible – itemized or not. Alimony payments are not considered part of your income.
However, if you established your divorce settlement on/after January 1, 2019, you do not deduct those payments from your taxes.
Your alimony recipient spouse does not also have to report the payments as income on their taxes. Thus, you must pay taxes on the alimony payments.
The idea is that your ex-spouse may not have to pay income taxes if they are not working, so you become liable for the payment.
Transfer of property as a non-taxable gift
The IRS can treat property transfers as a non-taxable gift, making you avoid taxes on your divorce settlement.
Spouses do not typically owe taxes for property transfers as a result of a divorce. The IRS (under Section 1041(a)) does not require taxes if there is a property transfer between you and your ex-spouse “incident to the divorce”
A property transfer is assumed to be incident to the divorce as long as it occurs within a year of the divorce or is called for in the divorce settlement. This is not applicable to alimony.
Thus, you have a year from the divorce date to settle up assets to avoid taxes on a divorce settlement, even with a written agreement.
If a property transfer is necessary within your divorce settlement, you have 6 years from the divorce date to make it. After that, the IRS will consider it a property transfer between two “unrelated parties” no regarding the terms of the divorce.
Under Section 2516, you can make arrangements for marital assets up to 2 years in advance of the divorce settlement. Section 2516 also allows you to make additional written arrangements up to 1 year after the final divorce.
The IRS considers any transfers made “for full and adequate consideration” if this section applies. This means giving something and receiving something of equivalent value in exchange.
This, therefore, does not change your total taxable wealth, so you do not owe taxes on the property.
Property transfer as part of divorce retains tax basis
Divorce proceedings do not have a step-up basis loophole. For instance, suppose you purchased a portfolio of stocks of $300,000 before the divorce.
This is its tax basis. The stocks appreciate over the years and are now worth $650,000. You will receive all the money during your divorce, then liquidate the whole portfolio.
The IRS considers the capital gains as $450,000 (the sale price of $650,000 less the original purchase price of $350,000).
During the divorce, the asset tax basis will not have changed. Thus, many parties look to claim more recently acquired assets during property division in a divorce.
Recently acquired assets may have appreciated less, so will have a smaller tax basis than longer-held assets.
Tax planning steps to consider in a divorce
Tax avoiding opportunities in a divorce settlement differ from other circumstances. Typically, however, you want to consider the following:
Alimony and IRAs
Taxable alimony counts as compensation when deposited into an individual retirement account (IRA).
If your divorce is signed on January 1, 2019, you do not use the money to contribute to an IRA or a Roth IRA without paying taxes on your alimony.
However, your alimony payments from your income taxes are deductible if you pay alimony and signed your divorce agreement on or before December 31, 2018.
You can negotiate to apply any loss carryforwards to your returns.
You can file a joint return if you are still legally married at the end of the year to likely save you money. Or, if you want to differentiate your finances from each other, select the married filing separately status.
Consider married filing separately if you do not want to be liable for your spouse, or for them being liable for your debts and finances. It is also useful in situations where you earn more money than your spouse, which incurs significantly higher taxes.
Filing as head of household will attract the benefit of a bigger standard deduction and better tax brackets.
This typically works when you would have:
- lived apart from your spouse for the last 6 months of the year;
- file separate returns;
- had someone depending on you live for more than 6 months of the year with you; and
- paid more than 50% of the upkeep for your home.
Try to get your divorcing partner to sign a waiver that keeps them from claiming an exemption for the child on their return if you are a non-custodial parent and your tax bracket is higher.
The exemption for a child can only be claimed by one parent, so claim their exemption when they waive it.
This is also applicable to the child tax credit and other applicable credits, deductions, or exemptions related to the child.
Include the costs of paying the medical bills of the child in your medical expense deductions if you keep paying them after the divorce. It does not matter if the child is in the custody of your ex-spouse.
The child’s medical bills could exceed the 7.5% threshold, and medical expenses are deductible when they exceed 7.5% of adjusted gross income.
A child’s college payment can be challenging after a divorce, especially when completing the Free Application for Federal Student Aid (FAFSA). However, the process can be faster and less confusing if you know the rules.
Read also: when can an omitted child fight a Will?
You might avoid taxes on the first $500,000 gain if you sell your home as part of the divorce. However, you must meet the 2-year ownership and use test.
Ensure to close the sale before finalizing the divorce to claim this exclusion. Nonetheless, selling your residence after a divorce can still qualify for a reduced exclusion even if you do not meet the full 2-year residency test.
For instance, if it was 1 year and not 2 years, you can each exclude $125,000 of gain.
Suppose you and your spouse continue to jointly own the home after your divorce. It is possible to then claim the tax exemption for the sale. You will only claim the individual exemption, which is worth up to $250,000.
You can be bought off the house from your spouse without triggering any capital gains. If you are paid your share of the home value by your spouse, divorce law considers it a marital transfer. With this, you receive the sale price of the home without paying taxes on it.
Work with a financial advisor
Although heartbreaking and frustrating, divorce can cause a complex financial situation. You need to work with a financial advisor during a time like this to help you make good financial decisions.
It does not have to be difficult to find a qualified financial advisor. The internet provides free tools that link you to financial advisors in your local area. Ensure to interview your advisor to know who is right for you.