Tax Implications of Divorce and Legal Separation

A dissolution of marriage or legal separation affects the tax situation of most couples. To that end, we encourage our clients to review their circumstances with a CPA or other tax specialist during the mediation process and before signing a Marital Settlement Agreement.

At the very least, most spouses will wish to consult IRS Publication 504. This well-written guide explains the federal tax rules for divorced and separated spouses, including the choice of filing status, entitlement to exemptions, the treatment of child and spousal support, and transfers of property such as retirement accounts that sometimes occur in a marital settlement. The following highlights are a basis that will further help you understand the tax implications of divorce and separation.

Filing Status

For divorced or legally separated spouses with children, the custodial parent (i.e. the parent who has more time with the children) may be able to file federal and state tax returns as head of household. Married persons who live apart may also qualify for this tax-advantaged status if they’ve lived apart for the last six months of the calendar year.

Dependent Exemptions

The IRS and California’s Franchise Tax Board allow parents to exempt a certain amount of income for each dependent child. The custodial parent has the right to these exemptions, subject to an IRS income limitation. However, he/she can transfer that right to the non-custodial parent by signing IRS Form 8332. The custodial parent often agrees to this transfer when the non-custodial parent is in a higher tax bracket. The exemptions then result in a greater tax saving, which the non-custodial parent can share with the other parent. In this way, the transfer of exemptions can save both parents money.

Child Tax Credit

The IRS and the Franchise Tax Board grant a Child Tax Credit for each dependent child. As with dependent exemptions above, the non-custodial parent may be able to claim this credit if the custodial parent signs IRS Form 8332.

Child-Care Expenses Credit

The IRS and the Franchise Tax Board also grant credits, subject to qualification, to a custodial parent who paid for care of a child under the age of 13 while the parent worked or looked for work.

Child Support

Child support is not a tax-deductible expense for the payer (supporting parent). However, child support is tax-free income for the payee (recipient). This applies for both federal and California income taxes.

Spousal Support

Spousal support is a tax-deductible expense for the payer (supporting spouse) and taxable income for the payee (recipient). This applies for both federal and California state income taxes.

Sale of the Family Home

If one spouse resides in the family home after the divorce or legal separation while the other (non-resident) spouse retains a financial interest in the home, the Marital Separation Agreement can include a provision to protect both the non-resident as well as the resident spouse’s entitlement to a $250,000 exclusion per person for capital gains tax whenever the home is ultimately sold. Ordinarily, a person is only entitled to the exclusion if he/she has lived in the home for at least two of the past five years.

Reporting Earned Income of Separated Spouses

Couples who are separated (i.e. living apart pending a dissolution of marriage or legal separation) and who wish to file separately should each report on their federal and state returns one-half of their combined income earned prior to the date of separation. They should also report one-half of their combined withhold-
ings to that date. After the date of separation, all earnings and withholdings are separate and are reported in full by the spouse to whom those earnings or with-
holdings apply.

Reporting Investment Income of Separated Spouses

Investment income — for example, stock dividends or interest from a certificate of deposit — remains community income until it’s divided. This division occurs when the court issues a decree of dissolution or legal separation. Prior to the decree, couples who wish to file separately should each report one-half of their combined investment income on the federal and state tax returns.