Getting a divorce can be a complicated process for many couples, especially those who have a substantial amount of assets. The way the property is divided is often a major point of contention among divorcing spouses, and in cases where there is a significant income disparity between the two, it is possible that the lower-earning spouse will ask for alimony/spousal support.
There is certainly a lot at stake with the division of marital assets in a divorce, but there is more to it than who gets what. Certain aspects of the dissolution of a marriage can trigger tax consequences, which could result in some unpleasant surprises during tax season. It is best to be aware of these issues while the divorce proceeding is ongoing, so they can be factored into the settlement negotiations, and so you can be prepared for them ahead of time.
Potential Tax Implications for Divorcing Couples
There are several potential tax issues that may come up during a divorce:
Changes in Tax Filing Status
When spouses get divorced, their tax filing status is likely to change after the divorce is finalized. Most married couples choose “married filing jointly”, although some (and particularly couples who are separated) choose “married filing separately”. Once the marriage is dissolved, the spouses will either file as “single” or “head of household” unless/until one of the individuals gets remarried.
It is important to point out that your tax filing status for the previous year is based on your marital status on the last day of the tax year, which is normally December 31. As an example, for the 2021 tax year, if you were still married through December 31, 2021, you would choose either “married filing jointly” or “married filing separately”. But if your divorce was finalized before that date and you were not remarried by then, your filing status would either be “single” or “head of household”.
Determining Which Spouse Receives the Child Tax Credit
Couples with children who meet the income threshold can qualify for the annual child tax credit. This is a fully refundable credit, meaning that taxpayers can receive it even if they did not pay any taxes that year. In 2021, the credit was as high as $3,600, paid to recipients in $300 monthly payments.
While the child tax credit is a wonderful benefit, only one of the parents is allowed to claim it during any given tax year. In some cases, the same parent claims it every year, which is typical when that parent has sole physical custody of the child. But in other cases, parents decide to alternate claiming the credit from year-to-year. This is something that should be worked out between the spouses in the divorce settlement.
Division of Retirement Assets
Cashing in all or part of a retirement account before the allowable age of distribution usually incurs a tax penalty. But one of the exceptions to this rule is when a couple gets divorced. The only catch is that the division of the retirement account must be structured properly. For example, the division of a 401(k) account requires a valid qualified domestic relations order (QDRO) to be issued by the court. A QDRO is not required for an IRS, but the spouses still need to follow IRS guidelines in order to transfer the account without tax consequences.
Non-qualified retirement plans such as traditional and Roth IRAs do not require a QDRO. With these types of accounts, the IRS allows a tax-free transfer of assets from the account by a divorce or maintenance decree.
Liquidating Real Estate and Stocks to Settle a Divorce
Transferring real estate, stocks, and other securities during a divorce is not generally considered a taxable event. However, if these assets are being liquidated as part of the divorce settlement, they could incur capital gains taxes. This is not so much of a worry with a primary residence as married couples normally have the first $500,000 in capital gains excluded from being taxed, but it could become an issue with other real estate property or stocks that have gained significant value since they were initially purchased.
Dividing a Business During a Divorce
When one or both spouses own a business, this can create additional complications during the division of assets, and sometimes it might trigger tax consequences. This depends largely on how the couple chooses to handle this asset.
If one spouse decides to buy out the other or the spouses decide to continue co-owning the business, then there will not usually be any tax implications, although this would also depend on how a buyout is structured. If, however, the couple decides to sell the business outright, then some portion of the proceeds of the sale could be taxable.
Contact a Reputable Alabama Family Law Attorney
When a couple gets divorced, they should definitely be aware of any potential tax implications that might affect their specific situation. Speak with a tax professional about how any of these issues might affect your situation; and be sure to work with a seasoned divorce lawyer who is committed to ensuring that your interests are fully protected throughout each phase of the proceeding.
If you are facing a divorce in Alabama, Stone Crosby, P.C. is here to help. To set up a consultation with one of our attorneys, message us online or call our Daphne, AL office today at (251) 626-6696. We look forward to serving you!