When undergoing a divorce, most couples just think about when they can get done with the hectic and emotionally draining process. This makes them overlook one key issue that could be costly and frustrating later on: taxation.
Sometimes the problems that arise out of poor tax planning during a divorce only manifest years after the divorce decree. This is why it is advisable to have an attorney guide you through the process so that they can guide you and assist you to make the right plans that help you avoid the negative tax consequences.
You can also avoid costly missteps and efficiently disentangle you and your partner’s financial lives by paying attention to these five critical considerations early on in the divorce process:
Determining the appropriate tax filing status
A couple’s tax filing status depends on their marital status by the last day of the year, December 31. If the divorce is not yet final, a couple can opt to either file as “married filing separately,” or file jointly.
While filing separately may be expensive, it allows each partner to be responsible for their individual tax obligations only. Filing jointly is cheaper, but it also means that the lower-earning spouse has to take a bigger risk as each spouse assumes responsibility for all taxes, interests and penalties.
After the divorce, the spouse who assumes responsibility for a dependent can file as “head of household,” which is quite cheaper.
Choosing the best time to finalize the divorce
Sometimes, it could be more advantageous to wait and finalize the divorce after December 31. For instance, where one partner has a significantly higher income, filing independently could result in a costlier tax bill than in the case of “married filing jointly.” However, if both spouses earn very high incomes, it makes more sense to file independently, since together they are in the highest tax bracket.
Determining who gets tax credits
It is impossible for both spouses to claim one dependent. This is why divorcing spouses have to familiarize themselves with the relevant IRS rules. The parent with physical custody will be entitled to a Child Tax Credit. However, it is possible to switch the credit from year to year, split multiple dependents or structure the divorce agreement in other creative ways.
Knowing the changes that have been introduced to alimony payments
A lot of expenses that were previously deductible were eliminated during a 2017 tax legislation. This includes alimony payments for the paying spouse, for divorce settlements concluded after December 31, 2018. This also means that the receiving spouse is no longer taxed when getting such payments. However, it is still possible for alimony-paying spouses who divorced before the legislation came into effect to take advantage of the deduction.
Coming up with the most practical way to transfer property
Property transfers that occur as the divorce proceeds are considered to be non-taxable events for gift taxes and federal income. However, sometimes it makes more sense to wait until at least a year after the divorce and create a taxable event by applying a “true sale” structure for the transaction. This option will allow the partner who buys the other’s property to get an increased cost basis on the said property.