From property division to alimony to child support to two attorneys’ fees, the tax code intersects with your divorce case in a myriad of ways. Here we will discuss the major areas where taxes and getting a divorce in Florida intersect.
The big difference between child support and alimony
Ironically many breadwinner spouses will find, say, a $2,500 child support payment to be more palatable than a $2,500 alimony payment. Emotionally, a payment that is designed to benefit children is easier to accept than a payment going to an ex-spouse.
Yet the child support payment will have to come from after-tax money. Also, there aren’t any standard deduction for child support payments at tax time.
Alimony, on the other hand, is taxable income to the receiving spouse and tax deductible for the paying spouse.
The receiving spouse will have to pay taxes on the alimony at the end of the year, and the paying spouse will have his taxable income reduced by the amount of the alimony.
That’s why it’s imperative to consider the tax implications of divorce or separation and with any alimony award.
In our example above, the breadwinner may cringe at the $2,500 alimony amount, but might be pleasantly surprised to find out that at the end of the day (depending on his tax bracket) he’s really only paying the equivalent of between $1,700 and $1,800 in after-tax money.
The $2,500 of alimony, therefore, is significantly cheaper for the paying spouse than paying the same amount in child support.
The receiving spouse, on the other hand, will put a premium value on child support payments, as the party will be able to keep every penny.
Understanding divorce tax implications when negotiating alimony
Because of the inherent tax nature of alimony, the spouse requesting alimony must account for taxes when when creating a separation agreement for alimony – to make sure there is enough cash flow to meet their budget.
Consider the case of a stay at home wife who is now newly divorced and struggling to find a job.
The wife will be relying exclusively on her alimony award to make sure that she can pay her bills and meet her other monthly expenses.
The gross number that the husband pays to the wife is irrelevant. What matters is what the wife will be taking home at the end of the day after paying the taxman. Therefore, in property settlement negotiations the wife’s divorce attorney will need to run tax calculations to show the wife what she’ll be taking home at the end of the day in her particular tax bracket. Presumably the wife will have already had a budget analysis done, even before inquiring for the filing status, so she’ll know whether the net alimony award after taxes will cover her expenses.
Gains or losses on investments are not taxable if one spouse transfers an asset to another party.
Generally, the government taxes gains from an investment at the time that they are sold.
So for example, if the husband owns $150,000 in Apple stocks and sells them to a third party, the husband will pay tax on his investment gains.
However, the husband may wish to transfer that Apple stock to the wife as part of the divorce settlement. The good news is that the IRS excludes transfers related to a divorce or separation from any capital gains tax. So the husband can transfer some or all of the Apple stock to the wife, and neither party will need to report capital gains or losses.
However, just because the wife doesn’t pay taxes now on the transferred stock does not mean our analysis ends. There is a hidden tax implication that will come due to the wife when she decides to sell her investment: the tax basis for calculating capital gains tax on the stock will carry over from the husband to the wife.
So we need to know how much the husband purchased the Apple stock for to understand the wife’s new tax basis on this asset. To properly value the wife’s share of the Apple stock, we need to account for what the taxes would be should the wife sell the stock today.
So in our example above, we learned that the husband had been an Apple fan for years and had purchased the stock for only $20,000. That would mean that the husband had gained $130,000 on his investment. All of these gains are taxable at 20%, and this tax basis will transfer from the husband to the wife with the stock. The clock does not reset; so should the wife go to sell the stock months after the divorce is finalized she will have to pay taxes on all of these gains.
Why is this a tax consideration in a Florida divorce?
In the vast majority of divorce cases we are trying to get to an equal division of assets and debts. If both parties combined are worth $800,000 at the time of filing for divorce, we’re going to want both the husband and the wife to each walk away with $400,000.
Some assets are easy to account for. $100,000 of cash in a savings account is worth $100,000. Period.
However, $100,000 of stock is almost never worth $100,000 to the party receiving it. When valuing an asset like stock, we have to figure out what the amount of money would be for the receiving spouse as if the asset were sold. And the only way to do that is to determine what the capital gains taxes are going to be on the investment during the dissolution proceeding.
Of course, the easy solution is just to take these assets, liquidate them during the divorce process, and distribute them equally. But a lot of times parties don’t want to liquidate their assets at the time of the divorce. These assets and investments are often vehicles to build wealth and/or earmarked for future retirement savings. And unless the parties are in severe financial straits, the best course of action is to try to preserve the investment portion of the marital estate and fairly distribute it.
Real estate and taxes in a Florida divorce
The same general principle of capital gains taxes applies to real estate as well. However, there is a pretty big exclusion: the first $250,000 of any realized gain on real estate for an individual and $500,000 for a married couple will not be taxed. So for the vast majority of people, taxes will not be a concern.
However, there are exceptions. A party looking to keep a home while going through a divorce needs to make sure that one does not apply.
First, people who purchased their home prior to 1986 (when the exclusion was placed into law) may still have to pay capital gains taxes on the sale of a home. And for parties that have owned a piece of real estate that long, it is likely that the capital gains tax comprises a significant portion of the value of the property.
Secondly, Even though the exclusion is $500,000 for married couples, if a party chooses to keep the home after the divorce but then wants to sell a couple years later, the exclusion will drop down to $250,000. That could mean a significant capital gains tax that might not otherwise been anticipated at the time of the divorce.
So for example, it is common for one of the parties in a divorce to keep the marital home for the children’s sake. But when the last child turns 18 and goes to college, the now single spouse may find himself or herself with too much house and wish to sell. That spouse might be shocked to find that they are over and above the exclusion and now must pay capital gains tax on their home after selling it.
Retirement vehicles like IRAs and 401(k)s also have tax implications that must be considered when getting a divorce in Florida.
First and foremost: 401(k)s and certain IRAs are funded with pretax money. That means when your employer takes out your matching 401K contribution every month, your employer is taking that off the top and the IRS is not including that money in your taxable income.
It’s a great deal in the long run because you can put more money into your investments and they can presumably grow over time depending on the market.
But at the end of the day when the money comes out of the 401K or IRA, the taxes will need to be paid on it.
Knowing this, we need to make sure we account for tax effects on retirement plans and reduce their value accordingly in settlement negotiations. Much like the Apple stock investment example above, the value of the retirement account quote in hand is not necessarily an equivalent amount in cash. In fact, the tax impact on retirement accounts will be even higher than the tax effect on investments because the income tax rate is higher than the capital gains tax rate.
As an example, assume a $250,000 401K accrued during the marriage is held in the husband’s name, and the husband plans to keep it.
To offset this asset, the wife will keep the home with net equity of $250,000. The home was purchased 10 years ago and if sold, would fall into a capital gains exclusion (no tax).
The husband will be getting the short end of the deal on this one. While on the surface both assets appear to be valued the same, the husband’s asset – should he cash it out – will be subject to 25% taxes. So the true value of the 401K is substantially less than the value of the home the wife is keeping.
Word-note: don’t get trapped in the idea of trying to decide whether the home or the stocks or the 401(k) is a better asset to keep. As long as you have properly adjusted the value on the asset and making sure that both parties have an equitable distribution, then you should be able to liquidate and investment and move it if that’s what you want to do.
A final note about qualified retirement plans like for 401Ks. While it is true that an early withdrawal subjected each party to early distribution fees and taxes, there are special orders call qualified domestic relations orders that can be signed by a judge. That will direct the plan administrator to transfer the balance of the 401K into another 401K for the spouse or an IRA for that spouse, without any tax effect at the time or any termination fees. Alternatively, the spouse can transfer the 401K to cash and specify in the order that any of the taxes paid on that cash withdrawal will be paid by the receiving spouse.
IRAs are usually not qualified plans and do not require any special order to be prepared. However, the divorce settlement agreement should be specific regarding how the IRA administrator is to distribute the funds and who should be taxed on the distribution.
The childcare dependency exemption
An often-overlooked aspect of taxes in a Florida divorce is the dependency exemption. Who claims the children on their taxes after the divorce is something that can be negotiated and agreed upon.
If the parties have relatively equal time-sharing, the appropriate solution is often to rotate the exemptions in cases of only one child, and split the exemptions in cases of more than one child. Note that while exemptions are indeed valuable, at times giving an exemption to a party will modify their net income and will cause a slight change in the child support.
In other cases, especially when one of the parents is maintaining a substantial portion of the overnights, that parent who has the children more often may keep the exemption.
If it is not been negotiated and agreed upon between the parties, then we use the IRS tiebreaker rules to figure out who is going to get the exemption. Simply, the parent that has the children for more than 183 overnights out of the tax year will get the exemption.
Sometimes, in contested divorce litigation, one of the spouses will race to their tax preparation company, file married but separately, and then claim all the children as exemptions. This can be problematic if the parent making the claim exercised less than 50% of the time-sharing with the child in the year preceding the actual filing. That’s because if both parents ultimately claim the child tax credit or tax exemptions, the IRS will conduct an audit and scan your tax return for tax liability and discrepancies, which will create a big mess.
Often, the best maneuver during a pending divorce is for both parties to be big boys and big girls, and do filing jointly (aka joint return), instead of filing separately. However, the only way to really know what the best deal is to talk to your tax preparation company and have them run calculations with all the different scenarios to determine your child tax credit and the best actions for your situation.
Regardless of which parent gets the dependency tax credit, both parents are able to deduct expenses related to childcare and medical health expenses during the course of the tax year.
Deducting attorney’s fees
Finally, there is the question as to whether the cost of your divorce attorney’s fees can be deducted at the end of the year. Unfortunately, in the vast majority of cases, attorney’s fees for divorce lawyers are not deductible by the IRS.
However, there are specific exceptions that can apply to at least a portion of your divorce fees. A spouse who is paying money to enforce collecting their alimony can itemize those specific divorce fees and deduct those from their taxes. Likewise, any of the time with your divorce lawyer that was used getting tax advice or advice on the property distribution can be deductible.
The best bet is to ask your attorney to itemize for you what portion of your attorney’s fees are deductible and not deductible. Your accountant can work with your divorce attorney to get this information in order to have a valid basis on which to deduct the appropriate fees.