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REAL PROPERTY, TRUST, AND ESTATE LAW: Making Divorce Less Taxing

By Justin T. Miller

To help make divorce a less taxing experience, this article discusses several issues that should be considered when dissolving a marriage.

Tax filing status. Two major tax issues divorcing spouses need to consider are when to time the divorce and how to file for tax purposes. The federal income tax filing status options for unmarried taxpayers are single, head of household, or qualifying widow(er).

Tax filing status is set by the spouses’ marital status on the last day of the tax year. Generally, spouses are treated for tax purposes as married for the entire year, even if they are separated, when they have not obtained a final decree of divorce or separate maintenance by the last day of the tax year.

While married filing jointly may provide a better tax result for both spouses versus married filing separately, a major risk to consider is that each spouse may be held responsible, jointly and individually, for the tax and any interest or penalty due on their joint tax return.

If spouses file separate returns as married filing separately, each should report only his or her own income, exemptions, deductions, and credits on the individual return. Each spouse is responsible only for his or her own taxes due on his or her own return—that is, no joint liability as with married filing jointly.

If a spouse was not married on the last day of the tax year and that spouse does not qualify to use any other filing status, the spouse must file a tax return as single.

If a spouse is unmarried and qualified to file as head of household, that spouse will receive better tax benefits using head of household filing status than using single filing status—although the Tax Cuts and Jobs Act of 2017 (TCJA) has limited the benefit after 2017 for head of household filers who itemize their deductions.

Dependency exemptions and child tax credits. The TCJA eliminated dependency exemptions for 2018 through 2025; however, it increased the child tax credit from $1,000 to $2,000 per child, and it increased the phase-out limit for the child tax credit. The child tax credit applies to a “qualifying child,” who must be under 17 years old as of the last day of the taxable year. For older children, a reduced child tax credit of $500 may be available. There are certain instances where it may make more sense for the noncustodial parent to claim the child tax credit—for example, where the custodial parent makes too much to benefit from the credit. While the TCJA is not clear, a custodial spouse should be able to give the benefit of the child tax credit to the noncustodial spouse—similar to what previously was allowed with dependency exemptions—if the custodial parent signs Internal Revenue Service (IRS) Form 8332 and the noncustodial parent attaches the Form 8332 to his or her return.

Sale of principal residence exclusion. In general, spouses may exclude from taxable income a substantial amount of capital gains on the sale of their principal residence if they have owned and used the home as a principal residence for two of the last five years, and they have not taken advantage of the principal residence exclusion within the last two years.

The exclusion amount from capital gains is $250,000 if single or $500,000 if married. To take advantage of the $500,000 exclusion amount: (1) the spouses must still be married at year end; (2) the spouses must file a joint income tax return for year of sale; (3) either spouse must meet the “ownership” test; and (4) both spouses must use the house as a principal residence.

Mortgage deductions. In general, single individuals and married spouses have a deductible interest limitation on $1 million of acquisition indebtedness, if the debt was incurred prior to December 15, 2017. Pursuant to the TCJA, the amount was lowered to $750,000 for acquisition indebtedness incurred on or after December 15, 2017. For the home mortgage interest deduction, the debt must be secured by a qualified home, which means a main home or a second home. The home must be used by the taxpayer as a residence—meaning the taxpayer uses it for 14 days within the year or for 10 percent of the time it is rented, whichever is greater.

Deductions related to divorce. In general, fees and expenses related to a divorce are considered nondeductible personal expenses. Prior to 2018, certain divorce-related fees that were attributable to the collection of income or tax advice have been deductible as miscellaneous itemized expenses. However, pursuant to the TCJA, miscellaneous itemized expenses are no longer deductible after 2017.

Allocation of tax carryovers. Tax carryovers—such as capital loss carryovers, charitable contribution carryovers, net operating loss carryovers, and passive loss carryovers—are property rights that have inherent value and must be considered in a divorce proceeding. To calculate the appropriate amounts for carryovers, spouses may need to go back and prepare “married filing separately” returns in the year when the tax loss was generated—solely for calculation purposes—and then prorate the loss between the spouses accordingly going forward.

Payments after divorce. Generally, child support payments are not tax deductible for the parent paying the support and not taxable income for the parent receiving the support.

Spousal support payments that qualify as alimony are tax deductible for the spouse making the payments, and the payments are taxable for the spouse receiving the payments, provided there is a divorce or separation instrument before 2019. Pursuant to the TCJA, there will be no deduction for payments of alimony and no inclusion of income for the recipient of alimony if there is not a divorce or separation instrument before 2019.

Life insurance commonly is used in a divorce context to ensure payment of alimony or child support. The proceeds of a life insurance policy received at the death of the insured are excluded from gross income for income tax purposes, assuming no transfer for value; however, there could be estate tax consequences if the insured retains any incidents of ownership in the policy.

Retirement accounts. A qualified retirement plan typically is set up by employers as an employee benefit. The transfer of all or part of a qualified retirement plan in a divorce or marital dissolution requires a qualified domestic relations order (QDRO). If structured appropriately, there are no tax consequences if the transfer from a qualified retirement plans is subject to a QDRO and is an eligible rollover distribution.

IRAs are governed by the Internal Revenue Code and are not subject to the Employee Retirement Income Security Act (ERISA); in other words, QDROs are not appropriate. A spouse may transfer an IRA tax-free only during a divorce situation; a spouse may not transfer an IRS tax-free to another spouse during marriage outside the divorce context. The transfer is not taxable if it is pursuant to a decree of divorce or separate maintenance or a “written instrument incident to such a decree” and transferred directly to the donee spouse’s IRA (Internal Revenue Code, Section 71(b)(2)(A)).

Property transfers and division of property. Transfers of property between spouses or “incident to divorce” generally are income tax free under Section 1041. A transfer is “incident to divorce” if (1) the transfer occurs within one year after the marriage ceases; or (2) it is “related” to the cessation of marriage. The Code also provides a number of ways for a property settlement to be accomplished without the transfer being deemed to constitute a taxable gift for gift tax purposes.

Support trusts in lieu of alimony. Alimony may not always be the best solution for both parties. The creation of an irrevocable trust by a wealthier spouse for the benefit of a less wealthy spouse in lieu of alimony (a support trust) may be preferable, especially to take advantage of potential estate, gift, and generation-skipping transfer tax savings. However, pursuant to the TCJA, if there is not a divorce or separation instrument prior to 2019, the wealthier spouse setting up the trust could be on the hook for taxes on all the trust’s net income for the rest of his or her life.

 


ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW

This article is an updated, abridged, and edited version of one that originally appeared on page 1 of Real Property, Trust and Estate Law Journal, Spring 2017 (52:1).

For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

WEBSITE: americanbar.org/rpte

PERIODICALS: Probate & Property, bimonthly magazine; Real Property, Trust and Estate Law Journal, published three times a year; e-Report, seasonal e-newsletter.

CLE PROGRAMS AND MEMBERSHIP: Watch out for RPTE’s monthly CLE webinars; for more information, please visit our website.

BOOKS AND OTHER RECENT PUBLICATIONS: Elder Law and Later-Life Legal PlanningAn Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business, 3d ed.; Leveraging Life Insurance Premium Payments;The German Inheritance and Gift Tax; Anatomy of a Mortgage: Understanding and Negotiating Commercial Real Estate Loans, 2d ed.Hydraulic Fracturing: A Guide to Environmental and Real Property Issues
.

ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW

This article is an updated, abridged, and edited version of one that originally appeared on page 1 of Real Property, Trust and Estate Law Journal, Spring 2017 (52:1).

For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

WEBSITE: americanbar.org/rpte

PERIODICALS: Probate & Property, bimonthly magazine; Real Property, Trust and Estate Law Journal, published three times a year; e-Report, seasonal e-newsletter.

CLE PROGRAMS AND MEMBERSHIP: Watch out for RPTE’s monthly CLE webinars; for more information, please visit our website.

BOOKS AND OTHER RECENT PUBLICATIONS: Elder Law and Later-Life Legal Planning; An Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business, 3d ed.; Leveraging Life Insurance Premium Payments; The German Inheritance and Gift Tax; Anatomy of a Mortgage: Understanding and Negotiating Commercial Real Estate Loans, 2d ed.; Hydraulic Fracturing: A Guide to Environmental and Real Property Issues.



ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW

This article is an updated, abridged, and edited version of one that originally appeared on page 1 of Real Property, Trust and Estate Law Journal, Spring 2017 (52:1).

For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

WEBSITE: americanbar.org/rpte

PERIODICALS: Probate & Property, bimonthly magazine; Real Property, Trust and Estate Law Journal, published three times a year; e-Report, seasonal e-newsletter.

CLE PROGRAMS AND MEMBERSHIP: Watch out for RPTE’s monthly CLE webinars; for more information, please visit our website.

BOOKS AND OTHER RECENT PUBLICATIONS: Elder Law and Later-Life Legal PlanningAn Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business, 3d ed.; Leveraging Life Insurance Premium Payments;The German Inheritance and Gift Tax; Anatomy of a Mortgage: Understanding and Negotiating Commercial Real Estate Loans, 2d ed.Hydraulic Fracturing: A Guide to Environmental and Real Property Issues
.