Key Tax Considerations for Family Law Practitioners - ABA YLD 101 Practice Series

By Susan F. McLerran

The prudent family law practitioner will consider the impact of federal income taxes when negotiating and evaluating possible scenarios for dividing marital property upon divorce.  Taking advantage of key tax provisions may allow your client to reduce potential tax liability and maximize assets subject to division.  The following tax issues frequently arise during the divorce process and may be helpful in optimizing a client’s property settlement:

Taxes Related to Transfer of Property Upon Divorce
The general rule provides that there will be no recognition of gain or loss related to the transfer of property from one spouse to a former spouse if the transfer is incident to divorce.  26 U.S.C. §1040.  This rule applies regardless of the character of property transferred or whether the property is divided equally or disproportionately. Though clients are generally protected from paying taxes when the marital property is divided and distributed in accordance with the terms of a divorce decree, many items of property may be encumbered with tax characteristics that can affect the true value of the asset to the receiving spouse.  The law of many states now requires or permits Courts to consider an analysis of the tax consequences of a property settlements.  Regardless of the status of the law in your state, it is advisable to prepare an inventory spreadsheet reflecting the after-tax values of the property and liabilities comprising the marital estate prior to settling the division of property.

Taxes Related to Retirement Accounts
When placing a value on tax deferred or retirement assets, the future taxation of the asset must be addressed.  Retirement assets, such as pension plans, 401(k) plans, and IRAs, are generally subject to taxation at the time of a withdrawal or distribution.  To protect a client who is receiving retirement assets in the divorce settlement, it is imperative to assess the potential tax liability associated with the assets.  Take for example a couple who have only two assets to divide: a checking account with a $25,000 balance,  and a traditional IRA account with a $25,000 balance.  Now assume that the husband takes the checking account and the wife is awarded the IRA, intending to make an “equal division” of the marital estate.  Despite the intentions of the husband and wife, is this an equal division?  Although the award of the IRA may have no immediate tax consequence to the wife, any future withdrawals from the IRA will be subject to a 20% withholding for taxes and will be included in the wife’s income for purposes of calculating her federal income taxes.  This division of property, although intended to be equitable, may not be, especially if the wife needs to access the funds in the IRA for immediate living expenses.  If the wife is under the age of 59 ½ at the time of making a withdrawal from the IRA, the withdrawal will be subject to a 10% penalty, in addition to the taxes that will be paid.

The 10-percent additional tax does not apply to distributions (from an IRA or qualified plan) that are made as part of a series of substantially equal payments that are made at least annually over the employee's life expectancy or the joint life expectancy of the employee and his designated beneficiary (I.R.C. § 72(t)(2)(A)(iv)).  Also, amounts paid from a qualified plan (an IRA is not a qualified plan) to an alternate payee in a divorce settlement pursuant to a qualified domestic relations order are not subject to the  additional 10% tax (I.R.C. § 72(t)(2)(c).

Alimony
Taxable alimony can be a valuable tool for both parties to a  property settlement.  Take the example of the high wage earning husband with significant deferred compensation benefits and the homemaker wife who cares for the children.  Assume the wife wishes to continue living in the marital home until the children graduate from highschool, but cannot afford the mortgage payment on her anticipated post-divorce income.  In this scenario, payment of taxable alimony by the husband to the wife may allow the husband to retain his deferred compensation while allowing the wife to retain the marital residence.  Further it will allow the husband, who is likely in a  high tax bracket, to deduct the alimony payments ,while the wife pays taxes on the alimony payments at a lower tax rate. 

A post-divorce payment from one party to another will be considered alimony if the payment is made in cash and (1) is not designated as non-alimony in the divorce or separation instrument, (2) is includable in the receiving party’s gross income, (3) if the spouses are legally separated, the payor and payee are not members of the same household at the time such payments are made, (4) the payments terminate in the event of the payor’s death, and (5) the payments are not treated as child support.  26 U.S.C. §71(a), 215(a).

Child support may not be disguised as alimony.  If there is any contingency of alimony that relates to a child, it will be strictly scrutinized.  An alimony contingency “relates to a child” if it depends on any event that relates to a child.  Events that relate to a child include the date the child dies, leaves the household, becomes unemployed, leaves school, marries, or reaches a certain age or income level. 

A major tax trap to avoid is the recapture of alimony.  If the alimony package you negotiate decreases or terminates during the first three calendar years, the alimony may be subject to the recapture rule.  Specifically, your client will be subject to alimony recapture if the alimony paid during the third year decreases by more than $15,000 from the second year, or the alimony paid in the second and third years decreases significantly from the alimony paid in the first year.  Unless an exception applies, the payor spouse will be required to “recapture” in the third post-separation year any “excess alimony” over the first and second years, reporting such recaptured amount as taxable income.  The Internal Revenue Service Publication 504 contains an alimony recapture worksheet that will aid in determining whether a client’s alimony package is safe from the tax consequences of alimony recapture.  Like most tax issues the family lawyer confronts in a divorce settlement, it is advisable for the client or attorney to retain a CPA to ensure that any alimony package will not be subject to alimony recapture to the detriment of your client. 

Dependency Exemptions For the Children
Generally, the divorced or separated parent who is the “custodial parent” is entitled to claim the dependency exemption for a qualifying child, unless the custodial parent executes a written declaration that he or she will not claim the child as a dependent for the year, and the non-custodial parent attaches this written declaration to his or her return..  26 U.S.C. §152(a), (e)(1)(2).  The “custodial parent” is the parent with whom the child lived for the greater number of nights during the year.26 U.S.C. §152(e)(1).

By using Form 8332 or similar statement, the custodial parent may release to the non-custodial parent the right to claim the dependency exemption.  The dependency exemption for children is frequently the subject of negotiation during a divorce, but it is important to remember that the dependency exemption is subject to phase-outs at certain income levels.  The amount you can claim as a deduction for the dependency exemptions is reduced once your adjusted gross income (“AGI”) reaches a certain threshold amount.  The dollar amount of the exemption is reduced by 2% for each $2,500 (or $1,250 if you use the married filing separately filing status) that your AGI exceeds the threshold amount.  For 2009, the threshold amounts were as follows: married filing jointly - $250,200, head of household - $208,500, single - $166,800, and married filing separately - $125,100.  If your client is the custodial parent and a high wage-earner, releasing the dependency exemption in favor of another asset of value may be a wise move.

Marital Residence

Exclusion of Gain
The Internal Revenue Code provides an exclusion of up to $500,000 of gain from the sale of a principal residence if the requirements of 26 U.S.C. §121 are met.  On tax returns filed under the “married filing jointly” filing status, the $500,000 exclusion applies if during the five year period ending on the date of sale of the property, (1) either spouse owned the property for two years, (2) both spouses used the residence as their principal residence requirement, and (3) neither spouse is ineligible for the exclusion because of use of the exclusion in the two year period preceding the sale.

In the context of a divorce, the husband and wife may each entitled to up to a $250,000 exclusion of gain.  For purposes of determining the exclusion, the period Spouse A owns the property shall include the period Spouse B owned the property. 26 U.S.C. §121(d)(3)(A).  Likewise, Spouse A shall be treated as using the property as his or her principal residence during any period of ownership when Spouse B was granted use of the property under a divorce or separation instrument.  26 U.S.C. §121(d)(3)(B).

Unless there is significant gain in the value of the residence sold incident to the divorce, it is possible that 100% of the gain from the sale of the parties’ principal residence will be excluded from taxation.

Deduction of Ad Valorem Taxes and Mortgage Interest
Generally, ad-valorem taxes paid by the owner or co-owner of property are deductible by the payor.  26 U.S.C. §164.  If both parties to a divorce suit are owners of the property and joint or community property funds are used to pay the ad valorem taxes, it will be presumed that each party paid 50% of the taxes.  If the source for the tax payment(s) is traced, this presumption can be rebutted.  Rev. Rul. 71-268, 1971-1 C.B. 58.

Like ad-valorem taxes, home mortgage interest paid on a qualified residence will be deductible by the payor.  26 U.S.C. §163.  Be aware that if the mortgage interest payments are made pursuant to temporary orders or a divorce instrument, the payments may be considered alimony under 26 U.S.C. §71 if the payments qualify in all other respects. 

Timing the Divorce
For purposes of filing a federal income tax return, the marital status of parties is determined as of the last day of the tax year.  For this reason, parties who may be wrapping up their divorce during the last few months of the year may wish to consult a tax advisor to determine whether there are tax advantages to divorcing before the end of the tax year or waiting until the new tax year begins.  If the parties are married on the last day of the tax year, they will have the option of filing their federal income tax returns under the “married filing jointly” filing status, which may reduce the parties overall tax liability for that year.  Alternatively, the parties may prefer to finalize the divorce before the end of the year, allowing the parties to file using the “single” filing status, and if certain criteria are met, permitting one party to take advantage of the benefits of the “head of household” filing status.

In conclusion, the family law attorney should rely on a CPA to provide answers to and advice regarding the tax questions that arise during the divorce process.  While the basic tax considerations mentioned in this article frequently arise in divorce cases, there are additional, complex tax implications that may be applicable to a case, depending on the parties’ assets and the fact-specific circumstances.  Proper tax planning during the divorce process will ensure that the client realizes 100% of the value of the client’s property settlement and is not faced with an unwelcome surprise on April 15th.  The saavy family law attorney will forge relationships with local CPAs early in his or her career so that these tax professionals can step in when tax issues and questions arise. 

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About the Author

Susan F. McLerran, Fullenweider Wilhite, P.C., smclerran@fullenweider.com

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