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How to Avoid Paying Taxes on a Divorce Settlement

Newly divorced woman checks her divorce settlement

Divorce settlements can be extremely complicated. While it makes eminent sense to work with a financial advisor as you plan your finances for a divorce, there are several key areas that can hold promise of avoiding or at least minimizing taxes on a divorce settlement. Before diving into specifics, it helps to get an overview of how divorce is treated by federal tax policy. Consider working with a financial advisor if you’re facing the prospect of a divorce or are currently in the middle of it.

Alimony and Taxes

Focusing on alimony and taxes in a divorce should be one of the ways to safeguard your money. As part of a divorce settlement, it is not uncommon for the higher-earning spouse to agree to alimony payments. These are structured payments that the spouse makes over a period of time, intended to make up for any income gap between the two now-former spouses.  Sometimes alimony payments continue indefinitely or until the recipient remarries.

Per the IRS, payments count as alimony under the following conditions:

  • The spouses don’t file a joint return with each other
  • The payment is in cash (including checks or money orders)
  • The payment is to or for a spouse or a former spouse made under a divorce or separation instrument
  • The spouses aren’t members of the same household when the payment is made (this requirement applies only if the spouses are legally separated under a decree of divorce or of separate maintenance)
  • There’s no liability to make the payment (in cash or property) after the death of the recipient’s spouse
  • The payment doesn’t count toward child support or a property settlement

Under certain circumstances, cash payments can include payments to third parties. However, in these cases, the payor cannot benefit from the alimony payments. For example, a payor might make alimony payments by paying the mortgage on the former spouse’s house. It would not count as alimony if the payor also continued to live in this home.

Again, per the IRS, alimony specifically does not include:

  • Child support
  • Noncash property settlements, whether in a lump sum or installments
  • Payments that are your spouse’s part of community property income
  • Payments to keep up the payer’s property
  • Use of the payer’s property
  • Voluntary payments

If your divorce settlement was established on or before Dec. 31, 2018, alimony payments are fully tax deductible for the individual making the payments, whether you itemize or not. For tax purposes, alimony payments are effectively not part of the payor’s income.

If your divorce settlement was established on or after Jan. 1, 2019, the person making the alimony payments cannot deduct those payments from their taxes. The person receiving alimony payments does not have to report these payments as income on their taxes. In this case, only the person making alimony payments must pay taxes on this money. The result is that an ex-spouse who does not work may not have to pay income taxes at all, while the payor pays income taxes for both households.

Marital Property Settlements and Taxes

In all ordinary cases, spouses do not owe any taxes for property transfers due to a divorce. This is controlled by two sections of the law: U.S. Code Section 1041(a) and U.S. Code Section 2516.

Under Section 1041(a), the IRS doesn’t require taxes when property transfers between former spouses if that transfer occurs “incident to the divorce.” Any transfer of property is assumed to be incident to the divorce so long as it’s either called for in the divorce settlement itself or if it occurs within one year of the end of the marriage.

This does not apply to alimony. As a result, regardless of a written agreement, ex-spouses have one year from the date of the divorce to settle up their assets with no tax implications. In this case, the IRS treats any property transfers as a non-taxable gift.

If a transfer of property is necessary within the divorce settlement, you have six years from the end of the marriage in which to make it. After that, regardless of the terms of the divorce, the IRS will typically consider this a property transfer between two unrelated parties.

Section 2516 allows couples to begin making arrangements for their marital assets up to two years in advance of the actual divorce settlement. It also allows you to make additional written arrangements for up to one year after the divorce is final. If this section does apply, the IRS will consider any transfer as made “for full and adequate consideration.” This means you gave something up and received, in exchange, something of equivalent value. As a result, your total taxable wealth remains unchanged and no party owes taxes on the property.

Tax Basis Transfers

IRS Form 1040

Any property transferred as part of a divorce keeps its tax basis. There is no step-up basis loophole in divorce proceedings. For example, say that you bought a portfolio of stocks for $200,000 during your marriage. This is its tax basis. Over the years it has appreciated, and today this portfolio is worth $500,000. During the divorce, you receive it entirely. Then you liquidate the whole portfolio.

The IRS will consider the capital gains as $300,000 (the sale price of $500,000 less the original purchase price of $200,000). The tax basis of these assets will not have changed during the divorce. As a result, many parties in a divorce look to claim more recently acquired assets when dividing up property. These will likely have appreciated less, and as a result, will have a smaller tax basis than longer-held assets.

Specific Tax Planning Steps to Consider During a Divorce

Your opportunities to avoid taxes in a divorce settlement will vary from those of others in similar but still unique circumstances. In general, though, it pays to consider alimony and IRAs, your filing status, who can claim minors as dependents, the cost of a child’s medical care, primary residence tax provisions and the possibility of a loss carry-forward.

1. Alimony and IRAs

Should you get taxable alimony, it will count as compensation if you deposit it into an individual retirement account (IRA). If you do not pay taxes on your alimony (for divorces signed on or after Jan. 1, 2019), you cannot use this money to contribute to either an IRA or a Roth IRA. If you pay alimony and signed your divorce agreement on or before Dec. 31, 2018, you can deduct the amount of your alimony payments from your income taxes.

To split a retirement account so neither person owes taxes after the split, it is usually necessary to have a qualified domestic relations order (QDRO). It establishes that one spouse has a claim to some of the other spouse’s retirement plan accounts. A QDRO states the dollar amount or percentage that belongs to the non-participant spouse and the number of payments or time period to which the order applies.

A QDRO can apply to any retirement or pension account covered by the Employee Retirement Income Security Act (ERISA). In other words, you don’t need a QDRO for individual retirement accounts (IRAs), which do not fall under ERISA. Instead, IRAs are under the typical distribution of marital assets as part of the divorce settlement.

One benefit of a QDRO is that it allows for early withdrawals from a 401(k) or other qualified retirement plans without incurring a penalty. As a result, if the plan allows it, an alternate payee can receive a lump sum or payments before reaching age 59.5 without a 10% IRS penalty.

2. Filing Status

If you’re still legally married at the end of the year, you can file a joint return (which is likely to save you money) or choose the married-filing-separately status if you want to keep your finances distinct from one another. Married filing separately is particularly useful for spouses who don’t want to take responsibility for each other’s debts and finances, and for situations where one spouse earns significantly more than the other (and so incurs significantly higher taxes).

You can also file as head of household and get the benefit of a bigger standard deduction and gentler tax brackets. This can only work if you lived apart from your spouse for the last six months of the year, file separate returns, had a dependent living with you for more than half of the year, and paid more than half of the upkeep for your home.

3. Child Care

"CHILD SUPPORT" spelled out in blocks

Exemptions for the Child Tax Credit don’t exist now, but may come back in 2025 if there’s no new law before then. The custodial parent can waive his or her right to claim that credit all the time or every other year.

If you’re a non-custodial parent try to get your soon-to-be ex to sign a waiver agreeing not to claim an exemption for the child on his or her return, especially if your tax bracket is higher. Only one parent can claim the exemption for each child, so if the custodial parent waives their exemption you can claim it. This also applies to the Child Tax Credit and other applicable credits and deductions related to your children.

If you keep paying a child’s medical bills after the divorce, you can include those costs in your medical-expense deductions – even if your ex-spouse has custody of the child. Medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income, but the child’s bills you pay could push you over the 7.5% threshold.

4. Primary Residence

If you sell your residence as part of the divorce, you may still be able to avoid taxes on the first $500,000 of gain, as long as you meet an ownership-and-use test for two of the last five years. To claim this full exclusion, you should make sure to close on the sale before you finalize the divorce. But even if you don’t meet the full two-year residency test, sales after a divorce can still qualify for a reduced exclusion. If, for example, it was one year instead of two, you each can exclude $125,000 of gain.

Failing that, let’s say you and your spouse still jointly own the home after your divorce. You can then still claim the tax exemption for its sale. In this case, you can only claim the individual exemption, worth up to $250,000.

Finally, your spouse can buy you out of the house without triggering any capital gains. If your spouse pays you for your share of the home’s value, divorce law considers it a marital transfer. This allows you to effectively collect the home’s sale price without paying taxes on it.

Bottom Line

There are several steps you can take to make sure that a divorce doesn’t mean a divorce from your money. In most cases the IRS does not tax property transfers between ex-spouses as part of the divorce process. For all divorce settlements reached after Jan. 1, 2019, meanwhile, the individual receiving alimony payments owes no taxes on that income. The person making alimony payments cannot deduct those payments from their own income. Given all the variables entailed in divorce and taxes it should be clear that having a financial advisor in the process is as important as having an attorney.

Tips on Divorce-Related Finances

  • Divorce can be heartbreaking, infuriating, frustrating and confusing. Unfortunately, it is also a very complex financial situation. That’s why working with a financial advisor can be so helpful during a time like that. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Now that you know how taxes after divorce work in theory, let’s look at the nuts and bolts in practice. It’s time, sadly, to talk about the practicalities of filing taxes after a divorce.

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