Hi Bank of Dad, I’m in the midst of filing for divorce. It’s amicable (mostly) but I know there are some major tax consequences to consider as well other financial moves to make to ensure I make some tax-smart decisions. If you could provide any assistance, I’d be grateful.” — Stephen, via email.
Dividing shared assets in a divorce can be a messy undertaking, no doubt. You’re wise to be thinking about the tax consequences of those decisions because what may seem like a good deal now could end up looking ugly after the taxman has his say.
Obviously, the tax impact of a divorce can be complicated, especially if you have complex assets or one of you owns a business. But here are some of the big factors you’ll want to think about in order to avoid a nightmare during the next filing season.
Understand the ‘Net Value’ of Any Assets
A lot of the assets you’re likely to divvy up with your spouse – say, a house, a car or even a Roth IRA – are things you’ve already paid for with after-tax dollars. Comparing them to traditional 401(k)s or IRAs, where you still have to pay income tax when you eventually withdraw that money, is comparing apples to oranges. That’s why the “net value” of assets, which takes future tax consequences into account, becomes imperative.
Other assets that could leave you with an eventual tax bomb are brokerage accounts, stock options and interest in a business. On a dollar-for-dollar basis, these pre-tax assets are going to be worth less than non-taxable possessions. “When you’re thinking about your divorce settlement, you want to think about those categories separately,” says Shawn Leamon, a Dallas-based Certified Divorce Financial Analyst.
Carefully Weigh Your Tax Filing Status
For tax purposes, you have the option of filing a joint return if you were still legally married on the last day of the year. Your tax filing status can have a huge impact on how much you owe the federal government, not to mention your state treasury, so give some thought to filing status before you file divorce decree.
For most people, a joint return is going to result in a lower tax bite, so you might want to file one last 1040 that way if possible. But there may be cases where going your own way makes more sense, even if it’s not your only choice. For instance, if one spouse significantly out-earns the other spouse, the one with a smaller income may actually have a lower tax liability for by using the “married filing separately” designation.
You may also want to file on your own if your spouse isn’t particularly trustworthy and sending in a joint return seems like a risky proposition, says Leamon, who hosts the popular Divorce and Your Money podcast.
Think About Kiddie Tax Breaks
If you have kids, you’ll also want to think about who’s going to count them as a dependent of their future tax returns, since only one of you can legally do so. That decision could affect a number of tax breaks, including the child tax credit, which shaves up to $2,000 off your tax liability for every child under age 17.
Keep in mind that you don’t have to be the parent with primary custody of the children in order to count them as a dependent as long as you file IRS Tax Form 8332, which transfers the children’s tax benefits to the non-custodial parent. “It’s something you’ll want to negotiate because it can be a savings of thousands of dollars a year,” says Leamon.
Pick the Right Time to Sell Your Home
Another factor potential tax trap in divorce: real estate. Leamon says that if you end up getting the home in the settlement and don’t plan to stay, it may be advantageous to sell while you’re still legally married.
Why? Because if, as a single filer, you lived in the house for two of the last five years and made less than $250,000 in profit, you won’t have to pay capital gains tax. But that exemption doubles to $500,000 for joint filers. So selling it before the year of your divorce sometimes staves off a huge bill from the IRS.
Understand the New Rules for Alimony
For a long time, alimony payments were tax-deductible for the spouse who provided them, and had to be reported as income for the person on the receiving end. That all changed with the Tax Cuts and Jobs Act, which affects divorce agreements from 2019 onward.
For all new settlements, spousal support won’t yield a tax break for the payer, nor does it count as income for the recipient. That’s something you’ll want to consider when haggling over how big those payments will be.
Find a Good CPA
Navigating the tax code is dizzying enough for couples who are still together – for those going through a separation, it’s especially complicated. Leamon recommends hiring a CPA to help guide you, at least for the year you get divorced and the year afterward.
These are probably some tense times, as you add the craziness of a break-up to your other daily stressors. A knowledgeable expert, Leamon adds, can help you navigate the special tax considerations that accompany a divorce and make sure you come away with a fair deal.