Implications of Legal Separation on Taxes
The legal separation process brings about a whirlwind of emotionally charged issues. Child custody, child support, alimony and dividing up marital property and debt frequently take up the vast majority of the mental attention a separating couple can devote to their case. In the midst of all this turmoil, however, the parties should take care not to forget about the tax implications of their case.
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Child Support and Custody
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Child support is nontaxable to the recipient and nondeductible to the payor. The child support guidelines of many states presume that the custodial parent, or the parent with whom the child spends the greatest percentage of overnights, will receive the benefit of declaring the child on her taxes in any given year. The IRS specifies that the custodial parent gets to claim the child, unless she executes Form 8832 to transfer this right to the other party. Parties frequently do this where transferring the dependency exemptions would result in a greater combined tax savings; in return for executing Form 8832, the custodial parent shares in the noncustodial parent's return. Where the parties share custody equally, the dependency exemptions for the children usually alternate from year to year. If the parties have two children, they can agree to each claim one.
Alimony
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Unlike child support, temporary or permanent alimony paid pursuant to a separation agreement or court order is tax deductible to the payor and must be reported as income by the recipient. Courts usually consider the tax implications of alimony payments when making their awards. Divorce lawyers negotiate alimony settlements with tax implications in mind and sometimes structure settlements where child support and property division payments masquerade as alimony in order to take advantage of this deductibility. In some cases, alimony payments reduce the payor's tax bracket but don't rise to a level that raises the recipient's. This can translate into more dollars in the recipient's pocket with fewer coming out of the payor's.
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Equitable Distribution and Community Property
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Property transfers incident to divorce are tax-free transactions under current law. As such, any payments one party makes to another to equalize a division of the marital estate are also tax-free, provided they are properly characterized. Major tax implications can arise from the liquidation of marital assets; while a transfer between spouses may be tax free, the same does not apply when the couple sells an asset. They may realize capital gains on the sale of stocks or investment property. Under current law, neither one will pay capital gains on the first $250,000 ($500,000 for both) in profit on the sale of a home that has been their principal residence for two of the last five years.
Filing Status
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A couple must actually be legally married on December 31 of a given tax year to claim married filing jointly status for that year. If they are legally separated, however, they may file jointly or separately. Generally, married filing jointly produces the biggest net savings, but every case is different. Parties should consult with a CPA before making tax filing decisions.
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References
- Photo Credit tax forms image by Chad McDermott from Fotolia.com
