Paying attention to your taxes while getting divorced can be a lot like walking a tightrope! It’s really easy to lose your balance. Having a safety net of professionals in addition to your attorney can prevent you from making fatal financial mistakes.
We see a lot of financials, stipulations & divorce decrees in our office. Most are well-drafted and cover all the bases. Every once in a while, we will have a tax or divorce client come in with a settlement agreement which created negative and unforeseen consequences. As all assets are not created equally, it's important to watch out for these and other issues before signing your decree.
IRS code 1041 allows for a non-taxable transfer of assets between spouses during a divorce. Sometimes our client’s assets include things like business interest, real estate or other assets that are titled and owned by another legal entity. While 1041 rules protect individuals, the case is not always the same for entities. Paying attention to titles & ownership will prevent unforeseen tax issues for you.
Employer sponsored retirement accounts such as 401k, 403b & 457 plans are split via a Qualified Domestic Relations Order, or QDRO. The IRS allows for penalty-free distributions from these plans for the non-employee spouse, which is referred to as the alternate-payee. It’s important to remember that while these distributions are not penalized, they are still considered taxable income. Additionally, the 10% penalty waiver does not apply to IRA accounts. Once those assets are transferred to the IRA in the new owner’s name, they are still subject to the normal distribution rules.
In high net worth cases it’s common for us to see capital loss carry-forwards from either stock or real estate. Capital losses occur when stock is sold, with a maximum loss of $3,000 per year. Any remaining amount is carried forward to the next tax year. Additionally, net operating losses (NOLS) from business or investment real estate follow somewhat similar but complex rules. NOLs can be carried back up to 2 years and carried forward indefinitely. For non-professional rental real estate, the losses start to phase out after $100k income and are capped at $150k. Anything partially or completely phased out carries forward. The IRS does not allow for a split or transfer of capital losses from one taxpayer to another. What this means is that the valuation and taxation of the asset could be overlooked. Therefore, attention to the ownership & title of the asset as mentioned above is extremely important.
Pay attention to your filing status, especially if your divorce is finalized late in the tax year. If you are the breadwinner and paying child support, more than likely your filing status will change from Married filing joint (MFJ) to Single. If this is the case, you must consider changing your tax withholding as you’ll be in for a nasty surprise come tax season.
Creative divorce settlements can help you maximize your income. As of midnight December 31, 2018, spousal support payments are no longer considered taxable income for any new divorce decrees. Any decrees signed prior to this date, including modifications, are grandfathered into the new tax law. Recently we had a client who’s soon-to-be-ex wanted to stay in the marital home. After consulting with us & his attorney our client agreed to a settlement where part of his spousal support was represented through the mortgage payments. Why was this important? Since he is still able to itemize, the mortgage payments and property taxes are still deductible on his schedule A. Had he just paid the support directly to her, he would have lost this favorable tax break.
As a Certified Divorce Financial Analyst, CDFA®, and Enrolled Agent, EA, I have a unique skill set that could mean a more equitable and financially independent transition for your divorce. You can contact us at email@example.com.