Tax Issues in Divorce

Also see my post "Do we file joint tax returns?"

By Eva Rosenberg, MarketWatch
New York Daily News - http://www.nydailynews.com
Sunday, September 24th, 2006

LOS ANGELES (MarketWatch) - Despite a divorce agreement that specifically said neither party shall pay or receive alimony, one reader, Divorced in New York, was hit with a $5,000 tax bill from the Internal Revenue Service for some phantom alimony.
Even though the IRS had a copy of the divorce agreement in hand, the agency insisted on assessing the taxes. Why? Because this woman's ex-husband presented canceled checks to prove he made payments to her in the amount reported as alimony. The IRS didn't really care that it wasn't alimony.

What were the payments? They were her portion of his monthly pension, as granted to her in the divorce. Unfortunately, the state was sending the money to Divorced's ex-husband, with the withholding already pulled out, and he was sending to her half of the net. Then, on his tax return, the ex-husband was deducting his full payment as alimony, and pocketing her share of the refund.

This problem could have been avoided if the attorney had set up a QDRO, says Patricia Powell, a certified financial planner and chief executive of The Powell Financial Group Inc., in Martinsville, N.J.

What's a QDRO? A qualified domestic relations order. Properly prepared, it instructs the pension plan to issue a check directly to the ex-wife for her share of the income.

With a QDRO, an ex-spouse can decide whether to get a lump sum rolled over to her IRA, cash it out and pay taxes, or continue to get monthly payments. She can designate how much she chooses to have withheld from her check. And, getting credit for her full share of the withholding, if Divorced had reported the pension income properly on her own tax return, she would have owed no tax.

This is a typical error when couples indulge in do-it-yourself divorces, said Lynne Gold-Bikin, chair of the family law practice group at Wolf, Block, Schorr and Solis-Cohen LLP in Norristown, Penn. Even seemingly simple divorces are more complex than they appear. They involve knowledge of both divorce law and tax law. Gold-Bikin says that if you're not a tax-law expert, you should get one to review the divorce agreement and settlement.

If your divorce doesn't get a tax tune-up, what kinds of errors are apt to occur? Here are some common problems.

Deceptive equality Often, assets appear to be evenly split based on fair market value. Everything looks all nice and equitable, but one person just got stuck with all the taxable assets, while the other walked off tax-free, warns Powell. One of the biggest traps for women, especially mothers, is that they often give up their right to practically everything in order to keep the house and avoid moving their children.

Here are some tax rules to consider:

Pensions, 401(k)s and IRAs are taxed at ordinary income rates. With the high distribution added to your other income, this can throw you into the top tax bracket of 35%.

Stocks and investments often get long-term capital gain treatment - limited to 15%.

The house looks like a good deal with that $500,000 personal residence exclusion. But once your ex signs it over to you, you've instantly lost half that cushion. If the appreciation on your residence is substantially more than the $250,000 personal exclusion, Powell advises you sell the house while you're still married and can use the full $500,000 joint exclusion. Then, split the money and buy your own home in the same neighborhood, which will now have a higher tax basis (basis is the cost, for tax purposes). Note: In most states, property tax keeps up with the increasing market value of the home. In California, due to Proposition 13, property taxes are based on the original purchase price. Before you do this in California, run the numbers to see whether the increased annual property tax payments on the new home might cost you more than the potential capital gains tax.

Cash is valued at face-value for tax purposes - there is no tax on cash!

How can you avoid the problem of "deceptive equality"? Powell suggests you sell off the assets with the high tax values and split the cash. Or if that's impractical, balance the split based on the tax costs. Have your certified financial planner or tax professional review the assets' tax bases to help you reach a truly equitable split.

The vanishing alimony trick Alimony recapture can be a common problem, cautions Gold-Bikin.

IRS Publication 504 explains what the recapture is: "You are subject to the recapture rule in the third year if the alimony you pay in the third year decreases by more than $15,000 from the second year or the alimony you pay in the second and third years decreases significantly from the alimony you pay in the first year."

Why is this recapture needed if the divorce agreement is properly drafted? Gold-Bikin said this often happens when the alimony payments aren't made on schedule. If several payments are missed in one year, then made up in another year, it's easy to see that $15,000 swing take place. Or if payments are stopped altogether and there haven't been three years of regular alimony payments, that would also trigger the recapture.

Why does this matter? Because the person paying the alimony will lose the deduction. And the person who received the money may go back and file amended returns for all the alimony years - and get refunds. Read that last sentence again if you're dealing with a deadbeat former spouse. You may have a refund coming!

How can you avoid this problem? Gold-Bikin recommends you adhere to the alimony payment schedule.

Vague assignments When the divorce decree awards family support without spelling out which part is for child support and which is for spousal support, it's all taxable to the recipient as alimony, and deductible to the payer, says Gold-Bikin. This the result of a 2005 Tax Court decision in Berry v. Commissioner.

How can you avoid this problem? Spell out how much of the support is designated for each child, and how much is spousal support.

Tax benefit tug-of-war One of Gold-Bikin's pet peeves is couples who fight over every smidgen of the tax benefits related to exemptions for their children, even when their income level causes them to lose those benefits.

Hope and Lifetime Learning Credits start to phase out for single or head-of-household filers when their adjusted gross income hits $45,000 and is eliminated entirely for those filers when AGI exceeds $55,000.

The deduction for student loan interest starts to phase out for single or HOH filers with adjusted gross income of $50,000, and is completely eliminated for those with AGI exceeding $65,000.

The child tax credit is lost when HOH income reaches $75,000.

Itemized deductions start to phase out at $150,500 for singles, HOH and married filing jointly

Personal exemptions phase out at incomes of $188,150 to $310,650 for HOH.

Landing in tax debtor's purgatory You probably know and pity many people who are stuck with divorce tax debt, and you wonder how they could have been so foolish, or trusting. They sign a joint tax return, even though they're getting divorced because they no longer trust each other. And they know better. But, "He promised to pay the whole tax!" is the usual refrain. Of course, he doesn't.

Powell says she's seen the most compelling and seductive behavior watching couples during divorce. The initiator of the divorce goes into courting mode, implying cooperation, an easy transition, or even a reconciliation - all the while, planning his/her wedding to someone else.

They effectively blindside their about-to-be ex into agreeing to practically anything, even to signing a joint tax return, when every fiber of their being is warning them away from this.

If you must sign that return, perhaps because it will reduce your own share of the tax liability, how can you best protect yourself?

Gold-Bikin says it's as easy as 1-2-3.

Get an indemnification letter as part of the divorce, making your ex responsible for his/her share of all taxes. And be sure that indemnification letter includes specific instructions for how any refunds are to be allocated. While IRS may not honor the agreement between the two of you, it does give you a basis to sue your ex, if you're ever stuck paying his or her share of the tax.

Don't ever sign a balance-due tax return without getting a certified check to pay your ex's share in full. Don't rely on promises from your ex or his/her attorney. They're rarely fulfilled.

If there is a refund coming, use IRS's new Form 8888 that allows you to have the refunds split up in any pre-determined allocation, and deposited directly to two different bank accounts.

Tune in, not out There are many, many more traps a divorcing couple can fall into. But, you're starting to get the idea. Even the simplest-seeming amicable divorce may have far-reaching financial implications.

Sweat the details, and don't just give up everything to get it all over with. You might think it's worth the price at the time because you're feeling emotionally out of control. Later, you'll realize just how badly you've been fleeced, and will spend years lamenting your decisions. If you can't face up to making the hard decisions, get a trusted family member or friend to work with you and your attorney, someone who can protect your interests.

Eva Rosenberg is the founder of TaxMama.com and an enrolled agent licensed to represent taxpayers before the IRS. She is the author of the new book "Small Business Taxes Made Easy." Reach her at [email protected].