The CPA Journal

Income Tax Issues Facing Divorced or Separated Individuals

By Richard Greenfield, Reminick, Aarons and Company, LLP

The large number of failed marriages in the United States has increased the number of taxpayers subject to the provisions affecting divorced or separated individuals. Awareness of these issues can make a substantial difference in the financial well-being of the parties. The tax planning for divorced or separated individuals should address all relevant concerns.

Filing status. Generally, if an individual has obtained a final decree of divorce or separate maintenance (as determined by state law) by the last day of the tax year, then that person will be considered unmarried for the entire tax year. Individuals that obtain a decree of annulment are also considered unmarried for tax purposes for the entire tax year and are also treated as being unmarried for all prior tax years. If they had filed as a married individual, they must file amended returns reflecting the change in status for all prior tax years that remain open under the statute of limitations.

Individuals that are separated but have not obtained a final decree of divorce or separate maintenance by the last day of the tax year are generally treated as married for the entire year for income tax purposes. They can choose to file jointly or separately; under certain circumstances, they can each file as head of household.

Dependency exemptions. In general, the decree of divorce or separate maintenance, or a written separation agreement, determines which parent has custody of a child. Otherwise, for tax purposes, the parent with custody for the greater part of the year is considered the custodial parent and can claim the child as a dependent because of providing more than half of the child’s support. The other dependency tests—gross income, joint return, and citizenship—must also be met.

The noncustodial parent can claim a dependency exemption for the child if any of the following documents are filed:

A written declaration stating that the custodial parent has no intention of claiming the child as a dependent, usually on Form 8332.
A decree or agreement, after 1984, stating that the noncustodial parent can claim the child as a dependent without regard to any condition, such as the payment of support.
A decree or agreement, before 1985, providing that the noncustodial parent is entitled to the exemption and has provided at least $600 for the child’s support for the year, unless it has been modified after 1984 to rescind the provision.

A written declaration from the custodial parent can release the exemption to the noncustodial parent for one year, for a period of years, or indefinitely. Both the custodial and noncustodial parent should carefully examine the period covered by the release in order to mitigate the effects of changing circumstances. For example, if the release is indefinite and circumstances change such that a noncustodial parent no longer provides child support, it may be difficult for the custodial parent to retrieve the release.

Alimony. Certain payments to a spouse or former spouse under a divorce or separation agreement are deductible by the payer and includible in the recipient’s taxable income. Alimony does not include child support, noncash property settlements, payments that are the spouse’s share of community income, payments to keep up the payer’s property, the use of property, or voluntary payments not made under a divorce or separation agreement. Alimony does include life insurance premiums that must be paid under a divorce or separation agreement on the payer’s life to the extent that the spouse owns the policy, and payments for the spouse’s medical expenses; and housing costs, taxes, or tuition paid to third parties as required by the divorce or separation agreement.

For a payment to qualify as alimony in a post-1984 instrument, the following conditions must be met:

The payment must be in cash.
The payment must be required by a divorce or separation agreement.
The divorced or legally separated spouses must reside in separate households when the payments are made.
Payments to a third party on behalf of the payee spouse must be supported by written evidence.
Liability for payment cannot continue beyond the death of the payee spouse.
The married payer and payee cannot file a joint tax return.
The divorce or separation agreement must not designate nonalimony treatment.
The payment cannot be child support.

Slightly different rules apply to payments seeking to qualify as alimony under a pre-1985 instrument.

Alimony payments required under a post-1984 instrument may be subject to recapture if, during the first three calendar years of payments, the second- or third-year payments decrease by more than $15,000 from the prior year. The sum of the excess alimony payments in the first and second years must be included in the payer’s income and deducted from the payee’s income in the third year. (See “Maximizing the Front-Loading of Alimony Payments,” by Bruce M. Bird and Mark A. Segal, The CPA Journal, February 2000.) Finally, alimony is treated as compensation for determining IRA contributions.

Child support. The payer of child support cannot deduct such payments; nor does the recipient include them in income. Child support payments must be either identified as such in the governing legal document or contingent upon events related to a child. Examples of such contingencies include the child’s death, departure from the recipient’s household, marriage, employment, completion of education, or attainment of a specified age.

Property settlements. Generally, gain or loss is not recognized on the transfers of property between spouses or former spouses that result from divorce. The recipient’s basis remains the same as the transferor’s basis unless the property was received before July 19, 1984, or under an instrument in effect before then, in which case the basis is the fair market value of the property (unless a Section 1041 election was made).

The family home is often transferred from one spouse to the other as part of the settlement. Under the new rules for excluding the gain from the sale of a principal residence, the recipient is considered to have owned the home during the transferor’s ownership. In addition, an individual is treated as having used the property as a principal residence during any period of ownership while the spouse or former spouse is granted the use of the property under a divorce or separation instrument. The spouse’s exclusive use of the marital home before the execution of the instrument, however, is not imputed to the nonoccupant spouse for purposes of qualifying for the deduction.

Retirement plan transfers. Under a qualified domestic relations order (QDRO), benefits from a qualified retirement plan may be transferred to a spouse, former spouse, child, or other dependent in connection with alimony, child support, or transfers of marital property rights. Such benefit transfers must be included in the recipient spouse’s income unless the distribution is an eligible rollover distribution and is rolled over into a qualified retirement plan or IRA. Benefits paid to a child or other dependent, on the other hand, are taxable.

Transfers of interest in an IRA to a spouse or former spouse under a written instrument of divorce or separation are not taxable. The transferee becomes the owner of the IRA for tax purposes. Cashing out the IRA, however, would create a taxable distribution [see Bunney, 114 TC No. 17 (2000)].

Community income. Married couples domiciled in a community property state during any part of a tax year may have community income. If they file separate federal income tax returns, each spouse usually reports one-half of any income treated as community income under state law. IRC section 66(a) provides a special rule for allocating community income if the following conditions are met:

The spouses are married to each other at any time during the calendar year.
The spouses live apart at all times during the calendar year.
The spouses do not file a joint tax return that year.
One or both spouses have earned income for the calendar year that is community income.
The spouses have not directly or indirectly transferred any of their earned income between themselves during the year.

The special rule permits the allocation of community income under IRC section 879(a), which treats community income as follows:

Earned income (other than partnership, trade, or business income) is treated as income of the spouse who performed the services.
Trade or business income (such as from a sole proprietorship) is allocated to the spouse carrying on the trade or business.
Partnership income is allocated to the partner spouse.
Community income that derives from one spouse’s separate property is treated as that spouse’s income.
All other community income is allocated according to the state’s community property law.

In addition, community property laws do not apply for federal taxation purposes to items of community income that one spouse treats as separate income without notifying the other spouse of the amount and nature of the income by the due date (including extensions) for filing the return. Likewise, a spouse is not responsible for reporting items of community income under the following conditions:

A joint return is not filed.
The item is not included on such spouse’s separate return.
Such spouse did not know, or have reason to know, of the item.
Under all of the facts and circumstances, it would be unfair to include the item in such spouse’s gross income.

Expenses incurred. The legal fees and court costs incurred to obtain a divorce are not tax deductible. Professional fees paid for tax advice in connection with a divorce and legal fees paid to collect alimony, however, are deductible as miscellaneous itemized deductions subject to the 2% adjusted gross income limit. Legal fees paid for a property settlement are generally not tax deductible, but certain fees may increase the basis of the property received.

Editors:

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Ira H. Inemer, CPA
Own Account

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