Tax Insights

This is part II of how to take care of your tax return when going through a divorce…

Payments to an ex-spouse

If you’re the spouse who is paying alimony, you can take a tax deduction for the payments, even if you don’t itemize your deductions. Keep in mind, though, that the IRS won’t consider the payments to be true alimony unless they are made in cash and spelled out in the divorce agreement. Your ex spouse, meanwhile, must pay income tax on those amounts. The opposite is true for child support: The payer doesn’t get a deduction and the recipient doesn’t pay income tax. (Be sure you know your ex spouse Social Security number. You have to report it on your tax return to claim the alimony deduction.)

Asset transfers

When a divorce settlement shifts property from one spouse to another, the recipient doesn’t pay tax on that transfer. That’s the good news. But it’s important to remember that the property’s tax basis shifts as well. Thus if you get property from your ex spouse in the divorce and later sell it, you will pay capital gains tax on all the appreciation before as well as after the transfer. That’s why, when you’re splitting up property, you need to consider the tax basis as well as the value of the property. A $100,000 bank account is worth more to you than a $100,000 stock portfolio that has a basis of $50,000. There’s no tax on the former, but when you sell the stock, you will owe tax on $50,000.

Home sales

If, as part of your divorce, you and your ex spouse decide to sell your home, that decision may have capital-gains tax implications. Normally, the law allows you to avoid tax on the first $250,000 of gain on the sale of your primary home if you have owned the home and lived there at least two years out of the last five. Married couples filing jointly can exclude up to $500,000 as long as either one has owned the residence and both used it as a primary home for at least two out of the last five years.

For sales after a divorce, if those two-year ownership-and-use tests are met, you and your ex can each exclude up to $250,000 of gain on your individual returns. And sales after a divorce can qualify for a reduced exclusion if the two-year tests haven’t been met. The amount claimed depends on the portion of the two-year period the home was owned and used. If, for example, it was one year instead of two, you each can exclude $125,000 of gain. What happens if you receive the house in the divorce settlement and sell it several years later? Then you can exclude a maximum of $250,000. The time your spouse owned the place is added to your period of ownership for purposes of the two-year test.

Transfer of retirement assets

Handle your retirement savings with care in a divorce. If you cash out a 401(k) plan to give the money to your ex spouse, for example, the IRS considers that a taxable distribution, and you’ll be stuck paying the tax. The way to avoid this tax trap is to have the transfer accomplished under a qualified domestic relations order (QDRO), which gives your ex spouse the right to the funds and relieves you of the tax burden. You don’t need a QDRO to transfer IRA funds, but the transfer should be spelled out in the divorce settlement so that it’s not deemed a taxable distribution.

 Danette Hefty, EA