How to avoid paying taxes on a divorce settlement? Divorce settlements are tough to negotiate. Working with a financial expert to arrange the finances for your divorce is highly recommended.
Still, there are a few crucial areas that can prevent or at least minimize taxes on your divorce settlement. It is helpful to have a general understanding of how divorce has been regarded by federal tax law before getting into the details.
If you’re considering getting a divorce or are in the middle of one, consider consulting with a financial advisor or a Las Vegas divorce lawyer.
This article will tackle how to avoid paying taxes on a divorce settlement. So keep on reading.
Alimony and Taxes
One way to protect your assets after a divorce is to pay attention to alimony and taxes. It is common for a spouse with a higher income to consent to alimony payments as part of the terms of a divorce settlement.
The spouse makes these planned payments over time to close any financial gap that may have existed between the two now-ex-spouses. Sometimes, the alimony recipient receives payments for life or until they marry again.
Payments under the following circumstances qualify as alimony, according to the IRS:
- The spouses don’t submit a joint tax return.
- Cash (including cheques and money orders) is required for payment.
- The payment is provided following a separation or divorce agreement with or for the spouse or ex-spouse.
- The couple isn’t living together when the payment is issued (this requirement only applies if a divorce decree or separate maintenance order formally separates both parties).
- Following the recipient’s spouse’s death, there is no need for payment (especially in cash or property).
- The payment is not deducted from a property claim or child support settlement.
Payments involving third parties may be included in cash payments under particular circumstances. However, the payor cannot profit from alimony payments in these cases. For example, the payor could pay the former spouse’s home mortgage to satisfy alimony payments. It wouldn’t be considered alimony if the payor also kept living in this house.
Once more, according to the IRS, alimony expressly excludes:
- Child support
- Noncash asset settlements, whether installments or lump sum
- Payments that constitute your spouse’s share of income from community property
- Payments made to maintain the payer’s property
- Use of the payer’s property
- Voluntary payments
Whether you categorize or not, the person paying alimony has a full tax deduction for the amount paid, provided the divorce settlement was reached on or before December 31, 2018. Alimony payments are not included in the payor’s income for tax reasons.
Alimony payments cannot be deducted from taxes by the individual paying them if the divorce settlement was finalized on or after January 1, 2019. The recipient of alimony is exempt from having to declare the payments of their taxes as income. In this case, the only party required to pay taxes on the alimony is the one making the payments. As a result, income taxes may not be due at all to an ex-spouse who is unemployed; however, the payer pays both households’ income taxes.
Marital Property Settlements and Taxes
Spouses do not generally owe taxes on property transfers resulting from a divorce. U.S. Code Sections 1041(a) and 2516 control this.
Property transfers between ex-spouses are exempt from IRS taxation under Section 1041(a) if they occur “incident to the divorce.” As long as it’s specified in the divorce settlement or happens within a year of the marriage ending, any property transfer is considered an incident of the divorce.
This does not cover alimony. Therefore, ex-spouses have a year from the divorce date without a formal agreement to divide their assets without facing any tax implications. The IRS regards any transfers of property in this situation as non-taxable gifts.
Six years after the termination of the marriage is the time to make any required property transfers as part of the divorce settlement. After that, the IRS will usually see this as a transfer of property between two unrelated people, regardless of the facts of the divorce.
Couples may start planning for their joint assets for up to two years before the formal divorce settlement under Section 2516. Additionally, you can continue to establish written agreements for up to a year following the finalization of your divorce. The IRS will treat any transfer as made “for full and adequate consideration” if this clause does apply. It indicates you give something up and gain something of equal value in exchange. No one owes taxes to the property, and your overall taxable worth stays unchanged.
Tax Basis Transfers
The tax basis of any asset transferred during a divorce is maintained. A step-up basis loophole does not exist in divorce procedures. For illustration purposes, assume you spent $200,000 on a stock portfolio while married. Its tax base is as follows. This portfolio has increased in value over time and is currently valued at $500,000. All of it is given to you during the divorce. After that, the entire portfolio is liquidated.
The IRS will recognize the capital gains as $300,000 (the $500,000 sale price minus the $200,000 original purchase price). These assets’ tax basis won’t have changed due to the divorce. As a result, when allocating property during a divorce, many parties try to assert ownership of more recent assets. These will have a lower tax basis than assets owned for longer since they have appreciated less.
What are the tax implications of a divorce settlement?
The tax implications of a divorce settlement can be complex and vary depending on several factors, including the specific terms of the settlement and the tax laws in your jurisdiction. It’s essential to consult with a qualified tax professional or family law attorney to get personalized advice tailored to your situation.
Here are some common tax considerations in divorce settlements in the United States:
- Property Division: There are typically no immediate tax consequences when assets are divided as part of a divorce settlement. The transfer of assets between spouses incident to divorce is generally tax-free. However, it would be best to consider the tax basis of the assets you receive because it can affect future capital gains taxes when you sell or dispose of those assets.
- Alimony and Spousal Support: Alimony, or spousal support, is taxable income for the recipient and deductible for the payer. It means the spouse paying alimony can deduct the payments from their taxable income, while the spouse receiving alimony must report it as taxable income.
- Child Support: Child support payments are typically not tax-deductible for the payer or taxable income for the recipient. They are meant to provide for the child’s well-being and are not considered taxable.
- Child Tax Credits and Dependency Exemptions: The IRS has specific rules regarding which parent can claim the child as a dependent for tax purposes. That can affect eligibility for child-related tax credits and deductions, such as the Child Tax Credit. Typically, the custodial parent claims the child as a dependent, but exceptions exist.
It’s important to note that tax laws can change, and divorce settlements can be highly individualized.
Working with a divorce lawyer in Las Vegas who can provide:
- Guidance specific to your situation.
- Ensuring compliance with current tax laws.
- Maximizing your financial well-being during and after the divorce process is essential.
Specific Tax Planning Actions to Take Into Account During a Divorce
You will have different chances to avoid paying taxes in your divorce settlement than others in comparable but distinct circumstances. However, it generally pays to consider things like IRAs and alimony, your filing status, who may claim minors as its dependents, the cost of the child’s medical expenses, the tax laws of your primary residence, and the potential for a loss carryover.
Alimony and IRAs
Depleting taxable alimony into an individual retirement account (IRA) will be considered compensation. If you have not paid taxes, you cannot utilize the money from your divorce settlement (divorces finalized on or after January 1, 2019) to make an IRA or Roth IRA contribution. You may deduct the amount of alimony you pay from the income taxes if you pay it and sign the divorce negotiation agreement prior to or on December 31, 2018.
It is typically required to have a competent domestic relations order (QDRO) to divide a retirement account so that neither party owes taxes following the split. It proves that one spouse is entitled to certain retirement plan accounts held by the other spouse. A QDRO specifies the number of payments or duration of the order and the monetary amount or percentage belonging to the non-participant spouse.
Any retirement or pension account protected by the Employee Retirement Income Security Act (ERISA) may be eligible for a QDRO. Stated differently, individual retirement funds (IRAs) exempt from ERISA don’t require a QDRO. Instead, IRAs are included in the standard division of marital assets as part of your divorce decree.
A benefit of a QDRO is that early withdrawals from qualified retirement plans (QDROs) such as 401(k)s are permitted without penalty. Because of this, an alternate payee may receive installments or a lump sum before becoming 59.5 years old without incurring a 10% IRS penalty if the plan permits it.
You have the option to file a joint return, which will save you money, or, if you choose to keep your funds separate from one another, you can file under the married filing separate status. When two married people file separately, it helps them avoid having to shoulder each other’s finances and debts, and when one makes a lot more money than the other (which means they pay a lot more taxes).
In addition, filing as the head of household offers you a higher standard deduction and more lenient tax brackets. It is only applicable if you file separate returns, have a dependent living with you for over half of the year, have paid over half of your home’s maintenance, and are separated from the spouse for the year’s final six months.
Child Tax Credit exemptions are not available at this time, although they might reappear in 2025 if no new law is passed before then. Either annually or every other year, the custodial parent could waive their right to get that credit.
Try to convince your soon-to-be ex to sign a waiver promising not to claim exemptions for the child on their tax return if you’re a non-custodial parent. It is essential if your tax bracket is higher. If the parent in custody refuses their exemption, you may be the only parent to claim an exemption for each child. That also holds true for any other child-related benefits, deductions, and the Child Tax Credit.
Even though your ex-spouse had custody of the child, you can deduct medical expenses from your taxes if you continue to pay the child’s bills after the divorce. The amount of medical costs you deduct is limited to 7.5% of your adjusted gross income; however, paying your child’s bills could cause you to exceed this threshold.
If you meet the ownership-and-use condition for two of the previous five years, you might still be eligible to avoid paying taxes for the initial $500,000 of gain if you sell your home in the course of the divorce. Ensure the sale closes before the divorce is finalized to be eligible for this complete exclusion. If you do not satisfy the entire two-year residency requirement, you may still be eligible to receive a reduced exclusion on sales following a divorce. For example, if it was only one year rather than two, each of you could deduct $125,000 from your gain.
If not, imagine you and your ex-spouse jointly owning the house following your divorce. At that point, you can still claim the sale’s tax exemption. You are limited to claiming the $250,000 individual exemption in this situation.
Lastly, your spouse might buy you out of the residence without incurring any capital gains. Divorce law views a payment made by your husband for your portion of the home’s value as a marital transfer. That enables you to get the house’s sale price without paying taxes.
You can ensure that your financial divorce doesn’t follow the divorce. Property transfers from ex-spouses during the divorce process are often not subject to taxation by the IRS.
Meanwhile, the recipient of alimony payments for any divorce settlement made after January 1, 2019, is not required to pay taxes upon that income.
It is not permitted for the alimony payer to deduct their payments from their income. Considering all the factors involved in divorce and taxes, it should be obvious how crucial it is to have a financial advisor or a divorce lawyer in Las Vegas, NV.
Suppose you need helpful advice or tips on safeguarding your financial future and minimizing tax liabilities during divorce proceedings. You may trust us at Donn W. Prokopius, Chtd. Schedule a consultation now by calling us