Tax season is a mere speed bump on your financial highway if you are facing a divorce. Most post-divorce life changes will indicate a change to your income taxes. Here are changes that may affect your taxes after divorce.
- Tax filing status may change
This is the easiest of the tax-planning areas to understand, because the rules are simple. Your federal filing status is determined by your marital status as of Dec. 31. Once your divorce is final, your filing status will change to either single or head of household. The main difference is that head of household has additional requirements related to maintenance of a household for a child with that home serving as the primary residence for them for more than half of the tax year.
- Homeownership deductions must be spelled out
If one party retains the home but you share the mortgage, who takes deductions for mortgage interest and real estate taxes paid? Generally, both ownership of the home and actual amounts paid for the mortgage dictate who gets to take the deduction and for how much. So if you share a mortgage, the deduction included on your tax return should reflect your proportion of the expenses paid. If your ex-spouse is paying something toward the mortgage post-divorce, he or she has the right to take deductions in proportion to the amount paid.
Sometimes, couples will retain joint ownership and share mortgage payments even after the divorce, most likely because of young children. In that case, deductions should be split 50-50. The IRS usually awards the right to claim the deduction to the party that proves payment came from separate funds.
Home mortgage interest and real estate taxes are usually significant itemized deductions that can reduce your overall tax bill. Have a clear understanding of who has the right to claim the deduction and accurately account for those payments. If you’re still in negotiations, be sure your lawyer includes this as part of your divorce settlement agreement.
- Claiming children as dependents part of agreement
Another deduction to address in the divorce settlement agreement is who can claim each child as a dependent. While exemption amounts can change from year to year, the 2017 exemption amount for one child is $4,050 and begins to phase out if the head of household income exceeds $287,650.
If the divorce settlement does not specify who gets this exemption, then the custodial parent gets to claim the child. More often, this matter is agreed upon during negotiations, and the exemption is traded or shared with the noncustodial parent by using IRS Form 8332. This could make financial sense for a couple if one spouse is in a higher tax bracket. For example, some typical settlements allow for one spouse to always claim the same child. Of course, that means the parent claiming the older child will run out of the exemption sooner.
Sometimes the couple agrees to trade off years. While exemptions can be negotiated like this, child-care credits go only to the custodial parent.
- Income and estimated tax payments will be different
Changes in income, plus alimony and child support payments, can affect the need to make estimated tax payments following a divorce. You’ll need to estimate the income tax impact of alimony and child support, whether you are the payer or the payee, and may need to make tax payments at the beginning of each quarter. You might want to enlist the help of a CPA to calculate the amount and file the paperwork for these estimated payments.
In the case of earned income from employment, you’ll need to recalculate estimated income tax. Tax brackets for head of household filers are lower than those for joint filers. So if you were the primary income earner, you may need to withhold more tax by reducing the number of exemptions on your W-4 to avoid penalties for underpaid estimated taxes.
- Dividing investments can be tricky
When transferring assets according to your settlement agreement, be sure that any retirement accounts transfer to you tax-free. Taxable accounts should include transfer of both the total value of the assets and the associated tax cost basis. Keeping track of cost basis also applies if you make improvements to a home. These expenses increase the basis of your home and should be carefully tracked.
Once you possess the assets, the focus shifts to understanding your total portfolio and the tax implications of making changes to your investment strategy. Now that you are single, you should review your asset allocation as you plan for your future. While you were married, your portfolio may have reflected a higher level of risk than you are comfortable holding. Or you may need to liquidate assets over time to meet living expenses. While changes may be called for to achieve a target allocation or implement recommendations from a new investment adviser, be sure to fully understand the associated tax bill before pulling the trigger.
This is also a good time to consider how much you have saved toward retirement. You should consider whether you qualify to make additional contributions to either a company retirement plan or an individual retirement account. Your income profile may have changed drastically from the prior year.
In cases where taxes are complex and assets are held jointly into divorce (i.e., commercial real estate partnerships, joint business ownership), you may want to remain a client of the CPA you used while married or find someone who can serve your needs as a single individual. We have compiled a comprehensive post-divorce checklist that you can download to make sure you follow through on critical post-divorce actions. Failing to complete these can have significant financial consequences.
Because your tax bill is the largest bill you will pay over your lifetime — more than your mortgage or college payments — understanding the subtler aspects of your taxes after a divorce is an important step in managing your wealth.