Nothing brings people together like a common enemy. Despite being torn apart by divorce, separating couples can benefit by coming together against the common enemy of the IRS.
During the midst of a divorce, emotions will inevitably run high, but former spouses should take care to avoid allowing emotions to interfere with their financial planning. Divorce in itself may be filled with regret but splitting spouses do not want to add financial regret to the pile. Dividing assets is a necessary part of the divorce process which should not be overlooked or taken lightly.
Avoid Any Post-Divorce Surprises From The I.R.S.
It is advisable that divorcing couples work with a CDFA® to avoid any post-divorce tax surprises.
DETERMINE YOUR FILING STATUS
Filing status is determined by the marital status as of December 31st.
The first step in ensuring divorcees do not fall prey to the IRS is to determine your filing status. Depending on the circumstances, individuals may be able to file jointly even while finalizing their legal separation as a couple.
Filing jointly can result in tax savings. If a divorce is not finalized as of December 31st, then separating spouses may still file jointly and capitalize on those savings. No matter how contentious the divorce, filing together can save you tax dollars. Filing jointly will generally lower the tax burden on both spouses depending on respective incomes, deductions, and credits. While there are significant advantages to filing jointly, individuals should keep in mind that both spouses are liable for taxes due as a result of audits on joint returns despite separation.
Understandably, separating partners may lack the requisite trust to file joint taxes. This should not deter joint filing, since the IRS has the following exceptions for relief should one spouse fail to report income, inflate a deduction, or fail to make a payment without the other’s knowledge.
1. Innocent Spouse Relief: The innocent spouse rule allows a taxpayer to avoid a tax obligation that is a result of errors made by a spouse on a joint return. In order to obtain relief under this rule, the innocent spouse must file for relief within two years of the IRS initiating collection.
2. Separation of Liability Relief: Under the separation of liability relief, a spouse can request that the IRS divides the tax liability between the two individuals. Each individual becomes solely responsible for his or her portion of the debt. A refund is not available under this type of relief and only applies to joint filers who are divorced, widowed, legally separated, or who have lived separately for the past 12 months.
3. Relief From Liability Arising From Community Property Law: In a community property state, marital income is considered to be earned equally. Whether the spouses file separately or jointly, they must each report half of the total marital income. When filing separate returns one spouse may not know the income of the other spouse and unknowingly exclude an item of income on the return.
4. Equitable Relief: If an individual does not qualify for Innocent Spouse Relief, Separation of Liability Relief, or relief from liability arising from Community Property Law, Equitable Relief may still be available. Under the equitable relief principle, the IRS will consider the overall situation to determine if full or partial equitable relief should be granted.
Note: IRS Form 8857, Request for Innocent Spouse Relief, is filed for each of the above provisions. Determination of qualification can take up to 6 months – during this time your ex-spouse will be contacted and you will both be responsible for providing tax information.
Filing a separate tax return can reduce the risk of mistakes, misrepresentations, or omissions from one spouse. Filing single or head of household will apply to those unmarried or legally separated on December 31st of the filing year. Individuals that file as the head of household will receive a higher standard deduction and be provided a more advantageous tax rate. To qualify as head of household, you must live separately from your spouse for the last 6 months of the filing year, have a dependent living with you for more than half of the year, and be responsible for more than half of your home upkeep expenses.
DISCUSS THE CHILD TAX CREDIT
Once filing status is determined, then separating couples should focus on maximizing the benefits of the child tax credit against the IRS. The child tax credit is worth up to $3,600 per child ages 0-5 and $3,000 per child ages 6-17 years. Individuals can take full advantage of the credit if their modified adjusted gross income is under $75,000 annually as a single filer, $150,000 as a married couple filing jointly, or $112,500 as an individual filing head of household. Those who make over the thresholds will receive tapering benefits.
The custodial parent, who the children live with the majority of the year is entitled to the credit. Couples should work together to determine where this credit can make the biggest impact. If the noncustodial parent is in a higher tax bracket, the credit may prove more beneficial to that individual. The custodial parent has the right to waive the credit each year agreed upon and give it to the non-custodial parent via IRS Form 8332. The noncustodial parent must include this with their tax return each year the credit is provided to them.
CONSIDER SELLING YOUR PRIMARY RESIDENCE
In many cases, selling the primary residence and splitting the profit equitably is the cleanest break and has tax benefits. Married couples filing jointly can avoid tax on the first $500,000 of gain on the sale if the following requirements are met:
- The home was the primary residence
- The couple lived in the home for at least two of the last five years
- The two-year exclusion has not been used in the last two years
Note: A couple may qualify for an exception to the rule if a move was due to a change of employment, health problems, or unforeseen circumstances.
If the above rules are met and one spouse chooses to retain the home and sells several years later, post-divorce they can write off $250,000 of gain on their individual tax return.
Example: Carmen and Steve own a dream home they paid $300,000 for and has increased in value to $750,000. If they chose to sell the home during the divorce process they could do so at no capital gain cost as their total gain is only $450,000. If Carmen retained the home and chose to sell it two years later for the same amount she would realize a capital gain of $200,000 as she now only gets to exclude $250,000 of the gain. At a 20% long-term capital gains rate the decision not to sell at the time of divorce would cost Carmen $40,000 in additional taxes that she could have avoided.
The W-4 tells an employer what percent to withhold from a full-time employee’s paycheck. Divorce will likely change an individual’s tax rate, especially if both spouses work. Continuing to withhold based on old, joint income can result in overpaying or underpaying on tax.
Summing up: Divorce settlement agreements should clearly establish how income earned and expenses paid during the marriage are to be reported to the IRS. To avoid filing inconsistent returns and IRS issues it is advisable that couples contemplating, experiencing, or transitioning through divorce work together when it comes to filing taxes.