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What are the tax implications of divorce?

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Aiman  Latif
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By Aiman Latif - Aiman's Bookkeeping, Payroll & Tax Services
Answered almost 5 years ago

The good news is that the Internal Revenue Service generally doesn’t consider the transfer of assets between divorcing spouses a taxable event. In general, if the divorce is the driving force behind the asset transfers, transfers can be made at will with little fear of taxation. For more information, please see IRS Publication 504.

The Marital Residence

Most often, the marital residence is the most expensive jointly-owned asset. Divorcing couples can sell the home now and divide the proceeds immediately, do this at a future date, or have one spouse buy the other’s interest in the property. When the marital residence is sold, taxpayers have a two-year deadline to reinvest the money if they wish to avoid the capital gains tax. But this two-year deferral only applies if the marital residence is the principal residence. The IRS says that as long as the house has been lived in at least three of the past five years, the two-year deferral applies. A problem arises when an ex-spouse lives in the house for more than two years after the divorce. Some heavy capital gains taxes may be in store for the other spouse when the house is finally sold, because the principal residence rule no longer applies to them.

If the marital residence is going to be sold, property transfer taxes are generally paid by the person selling the house. If either spouse knows that a sale may be required because they cannot financially afford to maintain the marital residence, it is best to sell the marital residence prior to the finalization of the divorce so that both spouses share the expense of the transfer taxes and other costs associated with sale.

Mutual Funds, Stocks, Bonds, Artwork and Other Appreciating Items

Many couples collect items during their marriage that will need to be divided during the course of a divorce. If any of these items are appreciating assets, their division should be carefully considered in light of the capital gains tax. For example, suppose a couple purchased stock some time ago for $50,000 and now, after accumulating value, it is worth $100,000. Because of a divorce, this stock is sold and divided. The capital gains tax would be applied to the profit the stock generated since its purchase, in this case $50,000.

On the other hand, suppose one spouse wants to keep the stock. In this case, he or she must purchase the other spouse’s share and they pay the other spouse $50,000. This makes the buyer’s total investment into the stock shares $75,000. However, for capital gains tax purposes, it doesn’t matter that the buyer actually invested $75,000, the government will considers the original cost basis of $50,000! Meanwhile the $50,000 paid to the other spouse goes to them tax-free.

Retirement Funds

Often, retirement accounts are the second largest marital asset. Tax laws regarding qualified retirement plans like 401(k)‘s are very strict and govern not only who receives the distributions, but also how they are handed out.

When divorce occurs, your ex-spouse may be entitled to some portion of your retirement plan. Divorcing couples must usually draft a Qualified Domestic Relations Order (QDRO). When written in accordance with the laws, the QDRO allows the ex-spouse the same distribution that they would have received if still married to the plan owner.

IRA’s function somewhat differently than qualified plans. If there have been contributions during your marriage, your spouse will have rights to some of the IRA assets. Such assets can be transferred tax-free by a written divorce decree. If you are the recipient of transferred IRA assets, be sure to have the funds rolled immediately into your own IRA. If you don’t, you could be hit with a 20 percent withholding penalty for federal income tax.

Income Taxes

If the husband’s and wife’s names and signatures appear on a state or federal personal income tax return, both are liable for the taxes. If a couple files jointly, the Internal Revenue Service generally holds each spouse responsible for the entire debt. This means that if the IRS conducts an audit and one spouse failed to accurately report their income or pay their income taxes, the other spouse could be liable for the taxes owed on a jointly filed tax return!

In some circumstances, a spouse who signed a joint tax return can be excused from liability if the spouse can prove that he or she is an innocent spouse. A wife or husband can be considered an innocent spouse if he or she did not know—and had no reason to know—that the tax return understated the true tax. If a married person wants full protection against possible liability for inaccurate tax returns filed by his or her spouse, the best approach is to file as “married filing separate return.”

Tax Implications of Support

If a spouse receives spousal support, APL, or alimony, the amount received usually is treated as income to the recipient and a deduction from income to the person paying the money. Furthermore, if one of these orders also contains an additional amount for child support, the entire amount received, including the child support component, may be considered income to the recipient for tax purposes unless the order of court states otherwise. If the order is solely for child support, there are no tax consequences for the receipt or payment of the money.

Dependency Exemption

Pennsylvania statutes provide that a judge in a child support case can award the dependency deduction to either parent based upon the incomes of the parties and the tax consequences of a support order. If no order of court is entered, the custodial parent generally is entitled to the dependency exemption when filing taxes.

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