It’s often said that there are really three parties to a divorce: the husband, the wife and Uncle Sam. In a sense, that’s right. Far too many people negotiate and finalize their divorce without taking proper account of the tax impact of the decisions they’re considering. Here’s a quick summary of some of the issues I see people miss most often:

Capital Gains on Your House

Capital gains taxes on home sales used to be a huge issue, but the tax bill that took effect in August of 1997 effectively eliminated the problem for the vast majority of homeowners. The law allows you to exclude up to $250,000 of the gain from taxable income if you’re single and $500,000 if you’re married. But one real risk remains: you can still take a serious hit if you wait too long after you move out of the house before you sell your interest in it.

The catch is that the house must have been your "principal residence" for two of the past five years when you sell it. That means that the house must be sold within three years of the time you move out. It’s common these days in divorce for one of the spouses to move out of the house but to continue owning an interest in it for several years. Once you’ve been out of the house for more than three years, though, it’s no longer considered your "principal residence." If it’s sold at a gain, you’ll owe tax on it. Even here, however, Congress has offered some help. The new tax law says that if you move out of the house and your spouse has the right to live in it pursuant to a divorce or written separation agreement, your spouse’s residence in the house will be counted as your residence for purposes of calculating the two-year residence requirement.

Alimony vs. Child Support

If you get alimony, it’s part of your taxable income. If you pay alimony, it’s tax deductible. Child support is not taxable or tax-deductible. So all other things being equal, the spouse who is paying support wants as much of it as possible to be considered alimony, and support recipients naturally want as much of the support as possible to be considered child support.

But all other things are not usually equal, especially when it comes to incomes. When the difference is significant, there may be an advantage to both spouses to make most of the payments in the form of alimony rather than child support, because the tax advantages of alimony leave more money for higher support payments.

It’s not unusual in divorce for the higher-income spouse to agree to pay the additional incidental expenses of the other spouse for a term of years, sometimes indefinitely. Typical payment arrangements might include medical insurance, life insurance, home mortgage payments and car payments. If you’re the one shelling out the money, it’s usually smart to take the time to ensure that the payments for each such expense qualify as alimony.

The same principle applies to the payments on a one-time property settlement in connection with the divorce itself. It’s often better for both spouses if these can be paid in the form of periodic alimony. Again, the paying spouse may need to increase the payments to compensate the receiving spouse for the cost of the taxes, but both spouses can end up with more money to spend.

A caution is probably in order here: precisely because it’s better for many couples to pay and receive support in the form of taxable alimony, the government has set up a multi-faceted system of restrictions that can be a trap for the unwary taxpayer who gets too greedy in characterizing support as alimony. One set of restrictions tests to make sure alimony is not "front-loaded" – that is, too concentrated in the period immediately after the divorce.

If the IRS decides what you’re calling "alimony" is really just disguised property settlement money – what the IRS calls "excess alimony" – you won’t be able to exclude it from your taxable income.

Another set of restrictions tests to make sure the alimony isn’t reduced or eliminated on a date corresponding to a date when one or more of the children reaches one of several specified ages, such as the age of majority There’s even a special test – I call it the "weird and wonderful" test – to make sure the alimony isn’t reduced or eliminated on two separate dates corresponding to a given age for two or more children.

If you flunk this test, the IRS will call your payments "alimony fixed as child support," and you won’t be able to exclude it from your taxable income.

Exemptions for the Children

Nearly all divorcing couples are aware of the tax exemptions for the children, and it’s typical for each spouse to believe that he or she is entitled to them. The IRS assumes that the spouse who has custody of the children is entitled to the exemptions, but the spouses are allowed to trade them back and forth freely, using IRS Form 8332. With the passage of the Tax Reform Act of 1997, the exemption now carries with it the right to use the $500 child credit for each child and to use the Hope Scholarship and the Lifetime Learning Credit for dependent college age children.

When there are multiple children, one option parents often use – usually the wrong one – is for the spouses to split the exemptions. This may feel fair to both spouses, but you’re rarely better off to share the exemptions. If one spouse’s income is substantially higher than the other’s, the spouses will be worse off, because they will have missed a chance to maximize tax savings.

The better approach is to consult an expert on tax in divorce who can calculate the value of the exemption(s) to each spouse. The one who can make better use of the exemption(s) should take all of them, and if appropriate, compensate the other spouse.

Child Care Credit

The parent who has custody of the children is entitled to claim a credit of from 20 percent to 30 percent of the cost of work-related childcare, up to a maximum of $960 for two or more children under the age of 13. Unlike the exemption, the childcare credit can’t be traded; it’s available only to the custodial parent. The fact that the custodial parent has assigned one or more exemptions using IRS Form 8332 has no effect on the ability to claim the credit for childcare expenses.

Filing Status

Your marital status for tax filing is set as of the last day of the year. So if you’re married on December 31 (and you file based on the calendar year, as most of us do), you must file as married (either jointly or separately). If you are divorced as of December 31, you must file single (either as head of household or not).

On average (and there certainly are exceptions), the tax rates get higher in the following order (meaning I’ve listed the most advantageous rate first):

  • Married filing jointly
  • Single Head of household
  • Single
  • Married filing separately

Timing of the Divorce

The marital status of the parties for the purpose of filing their tax return is set as of the last day of the fiscal year. A couple contemplating divorce near the end of the year should consider whether they would be better off making their divorce effective before the end of the year – allowing them to file as single taxpayers- or making their divorce effective after the end of the year, allowing them to file a joint return.

One caution about filing jointly: the less financially savvy spouse needs to understand that signing a joint return with his or her spouse exposes him or her to liability, even if he or she is not privy to all the calculations included in the return. An "innocent spouse" rule allows a spouse to escape liability in a few cases. It is narrowly drawn, however, and should never form the basis for planning.

Because trust is often at a low ebb as divorcing couples are preparing their final joint return, the less financially savvy spouse may decide to hire an independent accountant to review the return and its supporting documents before he or she signs it.

In fact, if you are divorcing and have property to divide or financial decisions to make regarding your children, a visit to an accountant could save you money.

SOURCE: Lee Borden  of divorceinfo.com, and Lawyers.com