Going through a Minnesota divorce is stressful, no matter how amicably you and your soon-to-be-ex are handling the process. Most people just want the divorce to be over so they can move forward with their lives. Unfortunately, agreeing to the terms of a divorce settlement without fully understanding the tax implications can cause even more stress when April 15 rolls around. Here are some issues you should think about, and discuss with your divorce attorney, so that you don't have unpleasant surprises when it's time to file your income tax return.
Believe it or not, until 1984, property transfers between spouses incident to a separation or divorce were treated as losses or gains for tax purposes for the IRS. The law has changed that, but that doesn't mean that property division has no income tax implications.
When it comes to property division, not all assets are created equal. Even if you and your spouse agree to split your assets so that you each have property that is equal in value, you may find that some of those assets carry a tax benefit while others carry a tax burden. For example, the spouse who keeps the marital home and the mortgage that goes with it will have an income tax deduction for mortgage interest paid. Depending on the size of the mortgage and the interest rate, this deduction can be considerable.
The division of retirement accounts also carries significant tax implications. For many couples, the retirement accounts of one or both spouses are some of the largest assets they have to divide. These accounts, which include 401(k)s and IRAs, may be partly or wholly subject to division, depending on whether part or all of them was accumulated during the marriage. Many retirement accounts must be divided pursuant to a Qualified Domestic Relations Order (QDRO) post-divorce. If properly divided, the company or financial institution administering the account can disburse each spouse's share to him or her without taxes or penalties, as long as the funds are deposited in another retirement account. If, by contrast, the account is simply closed and the proceeds divided, there could be penalties for early withdrawal and the proceeds may be considered taxable income, potentially putting the recipient in a higher tax bracket.
Alimony, or spousal maintenance, as it is called in Minnesota, is tax-deductible to the person paying it, and taxable as income to the recipient. Child support, on the other hand, is not. How spousal maintenance payments are structured may have an impact on taxes. "Front-loaded" spousal maintenance, or alimony that is paid in a large sum shortly after the divorce, may be considered a property settlement by the IRS, meaning no deduction would be allowed by the payor spouse. Similarly, spousal maintenance payments that terminate around the time a child reaches the age of majority may be found by the IRS to be child support in disguise. Again, the result could be that the payments would not be deductible to the payor.
For people who are used to filing joint tax returns as a married couple, income tax filing status can pose a dilemma at tax time. Should you file as single? As head of household? If you qualify for “head of household” status, that is generally the preferable status to use, as it entitles you to a larger standard deduction and may place you in a more desirable tax bracket. However, in order to qualify, you may not have lived with your ex-spouse at any time during the last six months of the relevant tax year, you must file separately, and you must have a qualifying child who resided with you for more than six months of the tax year in question. If you meet these criteria, you may qualify for head of household status even if your qualifying child can be claimed as a dependent by your ex.
Speaking of claiming children as dependents on your tax return: as a general rule, this privilege goes to the parent with whom the children live most of the time. However, many parents agree on a sharing of the dependent exemptions when child support is being paid, and many courts will impose a sharing if the parties cannot agree. The ability to claim a child for tax purposes may be more beneficial to one parent than the other, so it's worth discussing. If one parent is ceding the right to claim the kids to the other parent, there is an IRS form that he or she must sign indicating this.
Don't underestimate the importance of tax issues when negotiating the terms of your divorce. It's important to work with an experienced divorce attorney who understand how property settlements, support, and taxes intersect. We invite you to contact Bloch and Whitehouse, P.A. at (952) 224-9977 to schedule a free initial consultation. We look forward to working with you.