Filing status and divorce, tax implications and divorce, division of assets, gains from residence, child support and alimony, dependency exemption, and deductible costs in divorce.

1. Tax Consequences in
Divorce
September,
2012
Tsai Law Company, PLLC
Disclaimer: This presentation is from a Family Law Attorney Perspective and Washington State is a Community Property State. There may be other provisions
for a non community property state.

2. Filing Status-Divorce
 Clients want to know “how” to file- or the “status”:
on 1040, 5 different status:
 Single
 Married Filing Jointly
 Head of Household
 Married filing Separately
 Qualifying widow(er) with dependent child
Taxes and Divorce in Washington State

3. Married filing Jointly
 Married filing jointly-status on 12/31 determines how must file. Just because
opposing party filed wrong, does not mean client can follow along.
 Example- John is client, signed a Property Settlement Agreement on
December 20th resolving all issues in the divorce case. However, Divorce
Decree not entered until January 20th. Must file a tax return indicating
married status.
 Does not matter if settled issues in divorce, must enter divorce decree-
status of 12/31 determines filing status.
 May be tax advantages to filing a joint return-timing of when file the Decree
of Dissolution
 Be Aware of this, negotiate a settlement that includes possible benefit to one
or both parties
High Asset Divorce Lawyers

4. Married Filing Separately
1. A spouse in divorce can file separately
2. “Usually” not tax advantageous to do so
3. May want to avoid filing a fraudulent tax return
4. May want to avoid late filing
5. Accountant can calculate the taxes for client and run the two separate
returns
6. Sometimes, court may be upset if file separately. Court can order party to
reimburse other party.
7. Had judicial officer rule that they cannot order a spouse to file in a particular
manner. But can award other spouse the benefit of most tax advantageous
filing.
High Asset Divorce Lawyers

5. Head of Household
 Benefits to the filing status of head of household.
 A. ) Higher standard deduction
 B. ) Lower overall tax rate
 C. ) Ability to claim certain credits such as dependent care
credit and earned income credit.
 D. ) Need to know these issues regarding whether client can
receive the tax benefit associated with children-impact on
overall settlement if maintenance is also included
Common Tax Issues When Divorcing

6. Requirements to Head of
Household Status
 Unmarried or “considered unmarried” on last day of the
year Cannot claim this status if still married. Be careful when
entering the Decree of Dissolution. If it either benefits or has a
detriment to your client. Negotiate when Decree will be
entered.
 Paid more than half the cost of keeping up a home for the year;
- This can impact whether client qualifies for the status. Some
considerations including whether receiving maintenance and
paying, or whether other party was ordered to pay during the
pendency of the case.
 A “qualifying person” lived in their home for more than half of
the year.
High Net Worth Divorce in Washington

7. Tax Implications of Filing
Status on Case
 Taxes are considered when calculating child support to
determine net income
 Taxes are considered when calculating spousal
maintenance to determine net income
 Whether a party receives the tax exemption for a child
impacts income for living expenses
Child Support and Income in Washington

8. Joint and Individual Liability
for Married Filing Jointly
 Need to advise client of possible liability associated with filing of joint
return
 Example- one spouse not involved in business, has signed joint returns
in the past-is being asked to sign a joint return now.
 Duty to advise client to have own CPA look at return to be sure it is
accurate.
 IRS can go after either spouse for tax, interest and/or penalties
associated with incorrect filing.
 Client may have a claim for innocent spouse, will talk about later in
presentation.
Joint Returns and Business Assets in Divorce

9. Divorced Taxpayers
 IRS can hold a divorced spouse liable for unpaid tax, interest and penalty for a tax return filed
during the marriage. Should have this discussion with your client so they are aware of this
possible future liability.
 May want to include a hold harmless clause in the Decree for prior tax years if have concerns
about inaccurate taxes being filed.
 A hold harmless does not prevent the IRS from collecting jointly and severally from client, but
at least client has a remedy in divorce court should this happen.
 I have included language in Property Settlement Agreement that provides what the liability is
to the client in the future should the IRS perform an audit and claim taxes interest and
penalties are owed.
 May also want to include a provision that states if an amended return is filed, that any tax
refund shall be shared in a specific proportion.
 I have also included in a PSA that if an amended return is filed and a refund is due from the
IRS, that my client is entitled to a portion of the refund.
Property Settlement Agreements in Washington

10. Tax Impact of Division
of Assets
 First concept- Property Settlement or Award or Transfer of Property between
spouses incident to divorce is not subject to taxation pursuant to IRC 1041.
 To avoid the tax, that code provision provides 2 factors: (a) occurs within 1 year
of date of marriage ends, or (b) is related to the ending of your marriage.
 The specific time factor is pretty simple, the transfer occurs within one year.
The second disjunctive provision, “related to the end of your marriage” is more
broad.
 Related to the end of your marriage includes whether the transfer is made
under the original or modified divorce or separation instrument and the
transfer occurs within 6 years after the date the marriage ends.
 Tax Basis of the property received from your spouse is the same as the spouses
adjusted basis.
High Asset Divorce Lawyers

11. Gains from Sale of Personal
Residence
 Most people are not realizing gain from sale of personal residence. Many short sales and
foreclosures- also touch on those later
 If there is a gain however, IRC Section 121(b) provides that an individual may exclude
from income $250,000 of gain or $500,000 if status is married filing jointly.
 Test: Residence must be used as primary residence for two years over the past five years
and cannot have more than one sale within the past 2 years.
 If one spouse moved out of residence, for example, during pendency of proceeding, still
able to count as primary residence as long as other spouse was primarily residing
 Some people still have substantial equity in their residence and should advise clients of
possible tax ramifications of the sale of property.
 Do not want client thinking they will be realizing a specific amount of income-only to
have to pay in tax.
Division of Assets in Divorce in Washington

12. Other Exceptions to Sale of
Primary Residence
 The two out of five rule also has an exception to
activity duty military personnel in IRC 121(d)(9).
 Also, If there is a separate dwelling unit, in addition
to the primary residence, the sale of the dwelling
may be subject to taxation as it is not lumped in
with the primary residence.
Primary Residence in Divorce

13. Undifferentiated Support
Child Support versus Alimony
 Alimony is taxable to payee and tax deductible to the payor, child support is
not taxable to the payee nor deductible to the payor.
 Maintenance is an important tool for court to use to level the playing field
regarding income between the parties.
 Very important to be sure that alimony is clearly identified so that each party is
receiving the benefit of the bargain or ruling.
 When drafting language in a property settlement, decree or order, be sure and
identify what portion of a possible transfer payment is maintenance/alimony
versus child support.
 Otherwise, client may end up paying tax on support that was supposed to be
child support, which generally is not taxed.
 This is true for an order entered on a temporary basis as well as a final order.
So if you represent the primary parent of children, you want to advocate for a
specific child support amount to be part of the overall transfer payment so your
client does not end up paying tax on the whole.
Child Support and Alimony in Divorce

14. Lawton v. Commissioner
 In this case, tax court addressed a Pennsylvania temporary order that provided
support for support of spouse and one child. Wife argued that because the
state court was required to adhere to the mandated child support guidelines,
that a portion should be deemed non taxable child support.
 Court disagreed and indicated that IRC Section 71(c)(1) required that the
amount of child support must be fixed by the terms of the divorce or
separation instrument, not outside the instrument. The Court also pointed out
that the wife should have had the divorce court characterize the payment as
child support.
 You can bet that the wife specifically went back to her divorce lawyer and asked
why the support she received was not segregated between child support and
alimony.
 The safest thing to do is have it broken out so there is no question.
High Asset Divorce Lawyers

15. Dependency Exemption
and Credits
 The child dependency exemption is usually something that needs to be
addressed in divorce.
 If you represent the non primary parent or non custodial parent and that parent
is paying support, be sure to address the dependency exemption.
 If you are solely applying the Code, the parent who has the child or children for
more overnights in the year gets the exemption.
 If the parents have an equal number of overnights, the exemption goes to the
parent who has the higher adjusted gross income.
 Examples-(1) Absences (2) child goes to camp for 6 weeks during summer,(3)
parent works at night
Dependency Exemption in Divorce in Washington State

16. Qualifications of Dependent
Child
 (1) child must be designated as the child of the taxpayer in
the return
 (2) Child must not have reached age 19 during calendar
year or must be enrolled as full time student and not
reached age 24 in calendar year
 (3) child must have the same principle place of abode for
more than half year
 (4) child must not have provided more than one half of his
or her own support for the year.
High Asset Divorce Lawyers

17. Release of Exemption
FORM 8332
 If represent non custodial parent, may still claim exemption as long as divorce
court grants you the exemption.
 Divorce court cannot preempt IRC. Supremacy clause clearly trumps that
specific argument.
 However, divorce court has jurisdiction over ordering client to sign form 8332.
 Important to be sure that the Order of Child Support specifically grants the non
custodial parent the exemption and requires the custodial parent to sign Form
8332.
 For Orders entered prior to 2009, the order has to state: (1) that the non
custodial parent can claim the child without regard to any condition (2) the
other parent will not claim the child; and (3) specify the years for which the
claim is released.
Dependency Exemption in Divorce

18. Deductible Costs of Divorce
 While most costs incurred for a divorce proceeding are not
deductible, some costs of divorce are deductible.
 1. Fees for Tax Advice
 2. Fees to obtain or collect alimony
Deductible Costs in Divorce

19. Tax Advice-Deductible
 As part of the advice an attorney provides to a divorcing client, the client may receive the
tax benefit of deducting those costs on their income tax return.
 This includes advice for federal, state, local taxes, income, estate, gift, inheritance, and
property taxes., but is subject to the 2% limit
 The trick is to be sure that these costs are itemized on the attorney billing statements.
 If audited, want to be sure that the client has the billing statements that can be produced
to prove that the amount deducted can be clearly quantified.
 Do not want a client coming back to you years after the divorce is final, and asking you to
provide an itemized billing statement with the breakdown regarding the tax advice that
was provided.
 It is not a difficult thing to do at the time you are doing it. But could be a very difficult
thing to do years later.
Inheritance and Divorce

20. Fees Incurred Establishing or
Collecting Alimony-Tax Deductible
 Because Alimony is included in the recipient’s income for tax
purposes, the attorney’s fees incurred in establishing and
collecting alimony is tax deductible.
 Once again, important for the family law practitioner to itemize
these costs on the client invoice.
 Usually the issues that we address are custody, child support,
property and debt division and alimony. It is advisable to have
separate time entries for the alimony on the client statements so
they receive the benefit associated with those payments.
 Something easy attorney can do to be sure the client receives
the financial benefit.
Save Money in Divorce

21. Short Sales, Mortgage
Debt Relief Act of 2007
 Earlier discussing that many client’s going through divorce do not have equity
to divide.
 After the housing bubble burst, many people were forced into foreclosure
and/or having to do a short sale of their home.
 A short sale is when the bank is agreeable to accept a reduced amount of the
mortgage to transfer title to a buyer so they receive something other than the
residence.
 Generally, banks do not like to be in the position of having to own and maintain
residential real estate.
 So what happens is the bank forgives a portion of the debt associated with the
loan just so they get something and do not have to foreclose and possibly get
less than what a willing buyer would pay.
Real Estate and Divorce

22. Short Sales in Washington
 When the bank forgives a portion of the debt associated with the loan, that forgiveness
now becomes taxable income.
 Due to an outcry of homeowners who were losing their homes, and also then having to
pay an additional tax on the forgiveness, a double whammy, the Mortgage Debt Relief
Act was passed into law.
 What that law provides is that tax payers can exclude from their income cancelled debt
owed on their principle residence as long as the mortgage was to buy, build or
substantially improve the persons main home.
 That does not mean that a person can refinance their residence, pay off their credit cards,
then do a short sale and have the debt forgiven along with the tax owed.
 Publication No. 4681 Canceled Debts, Foreclosures, Repossessions and Abandonments
provides some specific examples of what situations are covered and what situations are
not covered.
Short Sales in Divorce