This time of year, most people’s minds begin turning to madness, basketball and golf. But it’s also tax time, and if you are divorced or divorcing, you could run into trouble if you are unaware of the potential traps that await the unwary.
First a review. There are three primary issues when you divorce: dividing property; paying or receiving alimony (or maintenance or "spousal support"); and paying or receiving child support. How these three issues are resolved is what funds the retirement accounts and vacations home purchases of divorce attorneys everywhere. Yet, once the divorce is over, you’ll understand that knowing the tax code and its regulations is nearly as important as familiarity with the substantive domestic relations law in your jurisdiction.
Here are the basics to bear in mind during this pre-April period.
Asset transfers between spouses, consequent to a divorce or legal separation, are generally tax-free affairs. Care of §1041 of the U.S. Tax Code (USC), there is no realization of a gain or loss upon transfer of property, so long as the transaction is “incident to a divorce,” takes place within a year and the recipient of the property is not a “nonresident alien” (if so, you must seek special help to deal with the tax consequences of what are typically tax-free property transfers).
Yet even without a nonresident alien spouse, there are still tricky areas that require special attention because they are not tax-free under §1041. Expert help is required if any third party transfer–say, involving a stock redemption–is involved. Also, if you are divvying up marital property that includes U.S. savings bonds, whoever does the transferring must report the interest on those bonds as income for the year before the divorce. Thereafter, whoever receives those bonds becomes responsible to report interest as income
But even if § 1041 protects your property transfers from immediate taxation, be cautious about what you agree to give (or take) in your divorce, as you will receive each asset with the transferrer’s basis. So, if you plan on taking that Google (nasdaq: GOOG – news – people ) stock worth $10 million (obtained from your spouse’s judicious choice of employment in 1997 and her consequently wildly lucrative stock options); you will face a huge capital gain exposure when you eventually sell those shares for $430 each, considering your ex got them for $10.
In this example, you’d be better off taking an asset of similar value but a higher basis or, best yet, cash. Similarly, if you owned lovely rental units, which you’ve depreciated to the fullest, you take that property with its reduced basis. Always look to the latent tax bill whenever you agree to “take” an asset in a divorce decree. And make sure that you agree or get an order to have access to all records that would allow you to prove to the IRS what the cost–or adjusted–basis of each asset actually is.
Alimony, as you probably know, is fully taxable as income to the recipient and provides an “above the line” deduction for the payer, provided the conditions of §71 are met. ( See U.S. Code Collection, Cornell Law School.) In other words, to qualify as alimony, the payments must: be made in cash to–or on behalf of–a spouse (or ex); be pursuant to a written document (separation agreement or court decree); not be labeled as nonalimony (this condition reflects that spouses can agree that payments will not be taxable); made in a year that the spouses don’t file jointly (and don’t live together, if the divorce is final); terminate upon the death of the recipient spouse; and not be child support in disguise (more on this later).
Also, don’t try to “front-load” a property payment and call it alimony to take advantage of the deduction. If you do, your so-called “excess alimony” payments could be recaptured and those deductions will evaporate. To avoid recapture, make sure that the alimony obligation doesn’t decrease by more than $15,000 between years, one, two and three. (Consider an alimony trust for more flexibility.)
Now here’s the tricky part. If you are still in the midst of divorcing and are paying temporary support under a “pendente lite” (pending the suit) order, make sure you ask the judge or your attorney to carefully allocate what portion of your pendente lite obligation is alimony, and what portions are not (i.e., represent child support or payments that would not qualify as “alimony” under § 71). Notice: Spouses may reside in the same household and still deduct temporary support–so long as the other criteria are met; they just can’t file joint income tax returns for the year in question. Anyhow, if you don’t allocate your temporary support, you or your spouse could be in for a nasty surprise. For instance, you might try, as the payer, to deduct your unallocated pendente lite obligation as alimony, while your payee spouse objects.
Well, to date, if you live in Delaware, New Jersey, Pennsylvania or Virginia (jurisdictions within the Federal Third Circuit) unallocated temporary support will be considered taxable income to the recipient–you, as payer, win. (See Kean v. Commissioner, 407 F3d 186 (3rd Cir. 2005).) On the other hand, if you live Colorado, Kansas, New Mexico, Oklahoma, Utah or Wyoming (states in the Federal Tenth Circuit), unallocated support is not considered taxable to the recipient–and you, as payer, lose. (See, Lovejoy v. Commissioner, 293 F.3d 1208 (10th Cir. 2002).)
If you live anywhere else, you don’t know how your Circuit will rule (the only thing you do know is that the matter will be a proverbial federal case, as federal tax issues are not state court matters). So, avoid uncertainty and nasty tax court cases where you don’t know which precedent the court will follow: Label what each payment is for, and who, if anyone, is entitled to deduct those sums as taxable alimony.
Child support is never taxable to the recipient spouse, nor deductible by the paying spouse, as it’s not considered "income," but rather a payment that is owed on behalf of the child, who just happens to live in the other parent’s home. Don’t even think about labeling child support payments as taxable alimony. If these payments terminate upon an event associated with a child’s majority (attaining age 18 to 21) or emancipation (leaving school, entry into the armed services, marriage, full-time employment or, god forbid, death), then the IRS will go back and recalculate every penny you paid as nondeductible child support. Not only will you be taxed on that previously deducted income, you’ll likely face interest and penalties. Don’t do this.
Finally, what everyone wants to know: Can you deduct your divorce lawyer’s bill? Well, not generally, but it is possible. Under §212, the IRS allows deductions for legal fees incurred in the “production” or “collection” of gross income. Consequently, if you itemize and can prove that your lawyer helped you receive, increase or collect alimony payments, you can deduct her fees but only in connection with the alimony and only if they exceed 2% of your adjusted gross income. ( See U.S. Code Collection, Cornell University.)
You cannot deduct the legal fees incurred to stop or defend against an alimony action. You may, however, deduct legal expenses incurred to obtain tax advice–often encountered in a divorce. But, these fees must your own. (You can’t deduct any fees paid on your spouse’s behalf, no matter what they are for). To avoid any problems, your attorney’s invoices must be clear, separating the tax planning provided from the purely personal and nondeductible divorce-related services rendered. ( See Rev. Rul. 72-545, 1972-2 CB 179.) Also, if you acquired sole title to real property in your divorce, ask your attorney about adding those legal fees to its basis.
Please, consult with a tax professional to review your tax exposure or savings before your divorce is final. As they say, a person who is his own accountant has a fool for a client.