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Deeper in Taxes in Divorce

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.

One of the roles of the lawyer, accountant, or mediator in divorce is to help the divorcing couple understand the options available to them to minimize their overall tax burden. These decisions may help one spouse at the expense of the other, for example shifting taxable income from a higher income bracket spouse to a lower income bracket spouse. This makes sense if the higher income bracket spouse is willing to extend additional benefit to the lower income bracket spouse to compensate for the tax disadvantage, and both spouses can be better off.

 II.  Exchange of Property Incident to Divorce

A.  Pre-1984 Law.

Before 1984, the characterization of a transfer between divorcing spouses followed the so-called Davis rule.[1] 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 non-taxable. 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.

B.  §1041.

§1041 provides that neither the transferor nor the transferee are to recognize gain or loss on a transfer of property[2] to a spouse or, if the transfer is incident to a divorce, to a former spouse.[3] If the transfer meets the §1041 test, it will be treated as a gift.[4] The transferee spouse will take a carryover basis in the transferred property (equal to the transferor’s adjusted basis).[5] §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.[6]

C.  Transfers that Qualify for §1041.

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.

1.    Within One Year After Marriage Ceases.

The Regulations say this applies even to property acquired after the marriage ceases,[7] and that a transfer occurring within one year after the marriage ceases need not have any connection with the divorce.[8]

2.    Related to the Cessation of the Marriage.

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.[9]

3.    Transfers to Third Parties.

A transfer to a third party on behalf[10] of the spouse or former spouse can qualify for §1041 treatment, provided it meets one of three tests:

·         It is required by a divorce or separation agreement;

·         The other spouse or former spouse requests it in writing; or

·         The other spouse or former spouse ratifies it in writing after the fact. The ratification must state that the parties intend the transfer to qualify for §1041. And the transferor must receive the ratification before the transferor files a return for the year in which the transfer occurred.

Note that the §1041 treatment applies only to the transfer between the spouses; the “deemed” transfer from the transferee spouse to the third party is a taxable event.[11]

4.    Consequences of §1041 Treatment.

Neither the transferor (which can be either the couple or the one of the spouses individually) nor the transferee recognizes gain or loss on any transfer covered by §1041.[12] The transferee inherits a basis in the property equal to the basis of the property in the hands of the transferor just before the transfer,[13] even if there are liabilities encumbering the property that exceed the basis.[14]

D.  Qualified Domestic Relations Orders.

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.[15] There are several exceptions to this principle, the best-known and most significant of which deals with Qualified Domestic Relations Orders (QDRO’s).[16]

1.    Definitions.

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.[17] 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,[18] and so long as it states the following facts:[19]

a)   the name and last known mailing address of the participant and each alternate payee;

b)   the amount or percentage of the participant’s benefits to be paid to each alternate payee or the manner in which the amount or percentage is to be determined;

c)    the number of payments or the period to which the order applies; and

d)   each plan to which the order applies.

2.    Treatment of Former Spouse as Surviving Spouse.

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.[20]

III. Marital Home

A.  Introduction.

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.

B.  Normal Rule.

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.[21]

C.  Sales Before May 7, 1997.

For all sales of a personal residence before May 7, 1997, there is an arcane set of principles that leave the seller vulnerable to paying income tax on the capital gain unless he or she buys a house of equal or greater value within two years of the sale. Full details of these principals are available on DivorceInfo at http://www.divorceinfo.com/oldcapitalgains.htm.

D.  Sales On or After May 7, 1997.

A taxpayer selling a personal residence on or after May 7, 1997 may exclude up to $250,000 of the gain from the sale from his or her taxable income.[22] The house must have been the taxpayer’s principal residence for at least two of the five years preceding the sale.[23] If both spouses in a married couple meet the residency requirement, the maximum exclusion is $500,000.[24]

1.    Restriction on Repeated Sales

The exclusion is available so long as the taxpayer hasn’t excluded capital gains on a sale that occurred after May 7, 1997 but within two years of the subject sale.[25] There’s a saving provision, however, for taxpayers who have sold a house recently and are selling another house because of changes in employment, health, or unforeseen circumstances.[26] The taxpayer may exclude the gain that would otherwise be excluded, multiplied by a fraction whose denominator is 2 and whose numerator is the fractional number of years that elapse between sales.

2.    Divorce Related Provisions

There are two provisions of particular interest to divorcing taxpayers, related to the calculation of the two years’ residency requirement. A taxpayer who received the property from a spouse or former spouse in a §1041(a) tax-free transfer may include the spouse’s period of residence for purposes of the two years’ requirement.[27] Also, for purposes of determining the two years’ requirement, a taxpayer will be deemed to be using the house as his or her personal residence for any period during which his or her former spouse is granted the right to right to live in the house pursuant to a divorce or written separation agreement.[28]

3.    Opt Out Provision

The exclusion of capital gains from the sale of a home is not mandatory. A taxpayer may opt out.[29]

IV.Continuing Support

A.  Introduction.

Alimony (or “Separate Maintenance”) is included in the gross income of the payee spouse[30] and deductible to the payor spouse.[31] Child Support, on the other hand, is not included in the gross income of the payee spouse and not deductible to the payor spouse. Child Support is specifically excluded from the definition of Alimony.[32]

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.

B.  Alimony.

1.    Requirements.

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)   Payments must be in cash.[33] Checks or money orders payable on demand are acceptable, but not debt, property, or services.[34]

b)   Payments must be under a divorce or written separation agreement.[35]

c)    Payments must not be designated as not alimony.[36]

d)   Generally, payments may not be made while the payor and payee spouses live together.[37]

e)   Liability to make payments (or any substitute payments) must stop when the payee spouse dies.[38]

f)     Payments may not occur in a year for which the spouses file a joint tax return with each other.[39]

2.    Alimony Need Not Be Periodic.[40]

3.    Alimony Can Be Paid Directly to a Third Party

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.”[41] So can payments to a third party made at the request of the payee spouse.[42]

4.    Payment of Life Insurance.

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.[43]

5.    Excess Alimony.

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).[44] 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).

a)   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[45] is first paid (called the 1^st post-separation year). The second and third years are the immediately following calendar years (called the 2^nd and 3^rd post-separation years, respectively).

b)   Only the excess alimony paid in the 1^st and 2^nd post-separation years is subject to recapture. There is no such thing as excess alimony paid in the 3^rd post-separation year or subsequent years.

c)    The calculation of the front-loading rules[46] is a five-step process, working in reverse chronological order:

(1) Step 1 is to determine the excess of the alimony paid in the 2^nd post-separation year over the sum of alimony paid in the 3^rd post-separation year plus $15,000.

(2) Step 2 is to reduce the alimony paid in the 2^nd post-separation year by any excess calculated in Step 1.

(3) Step 3 is to find the average of the alimony paid in the 2^nd post-separation year (after reduction in Step 2) and the alimony paid in the third post-separation year.

(4) Step 4 is to determine the excess of the alimony paid in the 1^st post-separation year over the sum of the average calculated in Step 3 and $15,000.

(5) Step 5 is to add the results of Step 1 and Step 4. The sum of these two figures is the excess alimony that must be reported as income by the payor spouse and may be claimed as a deduction by the payee spouse, in the 3^rd post-separation year.

d)   Here are the calculations of the front-loading rules, assuming payments in the 1^st, 2^nd, and 3^rd post-separation years of $75,000, $60,000, and $40,000, respectively:

e)   The front-loading rules do not apply to payments that change because of the death or remarriage of the payee spouse,[47] 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.[48] They also do not apply to temporary support payments pursuant to Code §71(b)(2)©.[49]

C.  Alimony “Fixed” as Child Support

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.[50] Payments can be characterized as child support even though they are for the support of an adult child.[51] 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.[52]

1.    Contingency Related to the Child

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.[53]

2.    Reduction “Associated with” Child-Related Contingency

The statutory language in Code §71©(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.[54]

a)   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 18^th or 21^st birthday of a child, or in Alabama, the 19^th birthday.[55]

b)   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.[56]

c)    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.[57]

D.  Housing Costs.

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.

1.    Mortgage Interest.

a)   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.[58] Code §163(h)(5) states that a “qualified residence” must be either the principal residence[59]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.

b)   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.”[60] Note that even if the payment cannot be deducted as mortgage interest, it may be deductible as alimony.[61]

c)    Payments of mortgage principal are not deductible.[62]

2.    Property Tax

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.[63] If the property is sold in the middle of the year, the tax is 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.[64] If one spouse pays property taxes owed by the other spouse (or former spouse), the payments may constitute alimony if properly structured.[65]

E.  Child Care Costs

Code §21(a) allows certain taxpayers to claim a tax credit equal to from 20% to 30% of certain employment-related dependent care expenses. The credit is available to taxpayers who maintain a household[66] that includes one or more dependents who are either below the age of 13 or incapable of caring for themselves.[67] The credit applies to expenses of household services and care for dependents that enable the taxpayer to be gainfully employed. [68] In divorce, this credit is available only to the parent who has custody for a greater portion of the year.[69]

V.  Tax Filing, Exemptions, and Liability

A.  Tax Exemptions for Children

1.    Value of the Exemption

The value of the exemption to each parent is the sum of two values: the exemption itself and the $500 child credit. There’s a full description of the value at each level of income at http://www.divorceinfo.com/exemptions.htm. The exemption is also a prerequisite to claiming the Hope Scholarship Credit and the Lifetime Learning Credit for college tuition costs.

2.    Pre-1984 Law

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 and make them more certain.

3.    General Rule

The Code[70] now provides that a custodial[71] parent after a divorce is entitled to the dependency exemption for his or her child[72] even though the noncustodial parent pays more than half the support for the child.

4.    Exceptions to General Rule

The rule does not apply where the custodial parent releases his or her claim to the exemption for the year.[73] It also does not apply if more than half of the support is deemed received under a multiple support agreement.[74] 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.[75]

5.    Statutory Requirements

a)   Either (i) the child must be younger than 19 (or a student who is younger than 24) at the end of the year; or (ii) the child’s gross income for the tax year must be less than the exemption amount for that year.[76]

b)   The child may not have filed a joint return with his or her spouse for the tax year.[77]

c)    The child must receive more than half the child’s support from one or both parents.[78]

d)   Generally, the child must be a citizen, national, or resident of the United States.[79]

B.  Filing Status

1.    Marital Status

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.[80]

a)   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.[81] 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,[82] nor is a voluntary separation, even pursuant to a written separation agreement.[83]

b)   The “Abandoned Spouse[84]” Rule. A person who is still formally married can nevertheless file as a single person if he or she meets the following requirements:

(1) The person must file a separate return.[85]

(2) The person must maintain as his or her home a household where a child for whom the person may claim a dependency deduction lives for more than half the year.

(3) The person must provide more than half the cost of maintaining the household during the year.

(4) During the last six months of the year, the person’s spouse must not live in the same house.[86]

c)    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.[87]

2.    Filing Categories.

a)   The marginal tax rates generally are lowest for married individuals filing jointly.[88] They progressively increase for each category as follows: head of household; individual, married filing separately.

b)   Married filing jointly. This produces the lowest tax rates and the highest standard deduction. Filing jointly makes it impossible to pay alimony,[89] however, and it also introduces the specter of joint and several liability. Subject to the Innocent Spouse Rule,[90] 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.[91]

c)    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,