Tax Filing Issues for Divorcing Spouses

Norris Family Law

Q: I am separated and getting a divorce. What is my tax-filing status?

A: The answer depends on your marital status as of the last day of the year. If your marital status was terminated on or before December 31, 2007 (i.e., if it was “bifurcated” from the rest of your divorce case), or if you obtained a Judgment of Legal Separation on or before that date, you are unmarried for tax purposes and cannot file a joint return for 2007. You must file separately.

If you were still married on December 31, you have the option of filing separately or, if your spouse agrees, filing a joint return.

In either case (whether still married or not on December 31), a person may be able to qualify for filing as “head of household”. To qualify for this filing status, the person must have been separated for over half the year and provide the principal residence of a qualifying child.

Q: How do I decide whether it is better for me to file singly or jointly with my spouse?

A: There are a number of things to consider:

…..Which will result in a lower tax total? (You can determine this by asking your CPA or tax preparer.)

…..Are you willing to be “jointly and severally” liable for the taxes? What this means is that on a joint return, each spouse is responsible to the IRS for the taxes owed; if the full amount is not paid, the IRS can look to either party (often, the one with the more easily reachable income or assets) for payment. If your spouse is financially responsible, with a good history of on-time tax payments, filing a joint return may make financial sense. Otherwise, consider carefully whether you should take on the additional financial obligation.

…..When persons are in the process of a divorce, they often are uncertain as to who should take certain deductions, or declare certain income, because there are so many financial and property unknowns until their case is resolved. As a practical matter, it often makes sense for them to file a joint return to avoid having to argue over this (and possibly end up with filing inconsistent individual returns, which could trigger a tax audit).

…..Remember that filing jointly requires two willing spouses. It can only be done by agreement.

No one can force the other party to sign a joint return, and no judge can order it.

Q: Can my spouse and I decide by agreement which of us will file as “Head of Household”?

A: No. This is not a matter of agreement. It depends solely on whether the parent qualifies.

Q: Can we decide by agreement who takes our child (or children) as dependency exemptions?

A: Yes, parties can agree, or a judge can order this.

Q: If we were separated during 2007, and we file separate returns, who declares which items of income?

A: Unless the parties have a prenuptial or postnuptial agreement saying otherwise, all earned income (salaries, bonuses, and other compensation for work) is community (i.e., owned equally) if earned prior to the parties’ separation. Each party will have to report half the community earned income on his/her return. A person’s income earned after separation is l00% his (or hers), and is reported on that person’s tax return.

Tax issues are complex, especially so when persons are in the process of divorcing. You should consult with your CPA or other tax expert for information and answers specific to your individual financial situation.


Tax Rules When Selling Your Home

When thinking about selling your home, perhaps in connection with a divorce, it is important to keep in mind the rules for excluding gain on the sale. We find that many persons still think in terms of the old “rollover of gain” rules that were in effect several years ago. Remember, though, that the old rollover rules are gone. You no longer can defer the capital gain by rolling over the proceeds of sale into a new residence. Instead, certain exclusion rules apply. Here is a quick summary:

The amount of gain on the sale that can be excluded from capital gains tax is up to $500,000 if you are married and file a joint return. A single filer may exclude up to $250,000 on his or her return.

Taxpayers who jointly own a home but are not married to each other may each exclude up to $250,000 of gain attributable to their respective ownership interests.

To be eligible for the exclusion, a taxpayer must have owned the residence for a minimum of two years, have used it as his or her principal residence for at least two of the five years preceding the sale, and must not have used the exclusion within the two years prior to the sale. In certain situations, where unforeseen circumstances have arisen, a person may take a pro-rata exclusion amount based on how long he or she has lived in the home.

Important tip for separated parties: when one moves out of the residence, there should be a written order giving exclusive temporary use and occupancy to the other, to preserve for the “out spouse” as much as possible the residency time that he or she can claim under the exclusion rules.

A person will also qualify for the exclusion if he or she sells less than his or her entire ownership interest in the home (such as if the person sells an interest in the home to someone else but continues to live there). A later sale of the remainder of the interest, however, will be added to the original sale to determine the exclusion amount available at the later date.


Tax Issues for the Newly Single Person

Married persons typically file their tax returns jointly, but after a divorce they need to deal with new tax filing decisions and issues. Here are some of them:

Spousal Support: A person receiving spousal support must pay income tax on it at his or her ordinary income tax rate. A person paying spousal support may deduct it from his or her taxes. (Spousal support, however, by agreement of the parties may be made non-taxable and non-deductible by the terms of their marital settlement agreement, and in that case, the payments will be without tax consequences.)

Child Support: The person receiving child support does not pay income tax on it, and the person paying child support may not deduct it.

Dependency Exemption: In any given year, only one of the parents may claim a child as a dependent for tax purposes. The parent with custody for the greater portion of the year gets the dependency exemption. In shared custody, this means that the parent with whom the child lives for the greater amount of time gets the exemption. However, the court can order, or the parties can agree in their settlement agreement, that the dependency exemption will be transferred to the parent who has the child the lesser amount of time. It can make economic sense to do this where the parties’ respective tax brackets mean that a shifting of the exemption will result in less overall tax, and thus more money available for support. (A custodial parent also may release the exemption to the other parent by filing with the IRS a release form either on an annual basis, or once to cover future years.)

Head of Household: A parent can claim head of household filing status even if he or she does not have the dependency exemption for the child. To qualify, the taxpayer must maintain his or her home as the principal residence of the dependent.

Filing Status: The most favorable tax rates generally are “married filing jointly” or “head of household.” Usually filing as a single person is not as favorable. The least favorable category is usually “married filing separately.”

Significance of December 31: A person who is divorced by December 31 is treated by the IRS as unmarried for the entire year, and is treated as a single taxpayer. (This is why many persons elect to “bifurcate” their cases so that they get a judgment terminating their marital status by the end of the year, even if the rest of their divorce case has not been resolved.)

Estimated payments: Income that is not subject to withholding is, of course, taxed. For example, if you receive taxable spousal support, you may need to make quarterly estimated tax payments. These installment payments are due on April 15, June 15, September 15, and January 15.

Joint and Several Liability: Divorced spouses have continuing liability for their previously filed joint returns. This means that each is responsible for any taxes due on joint returns.

These are some of the common issues that divorced persons should be aware of. There are, of course, many other issues of much greater complexity. You should always get the advice of your CPA or other tax professional.

These are some of the common issues that divorced persons should be aware of. There are, of course, many other issues of much greater complexity. You should always get the advice of your CPA or other tax professional.