Since January 1, 2019, the tax rules for divorce instruments fall under dramatically new rules included in the Tax Cuts and Jobs Act (TCJA) of 2017. These law changes were largely made as a result of tax underreporting, meaning that the tax returns of recipients of alimony showed less income than the deductible alimony on the tax returns of the payer of alimony.
This article reviews the tax law changes in this new environment and how the TCJA of 2017 effected some of these provisions.
Alimony, Dependency, and Child Support
For divorce or separation agreements executed after 2018, alimony is no longer deductible by the payor spouse and is not included in income of the recipient. This guidance is straightforward and makes other pre-2019 complicating factors, including what constitutes alimony and the tax treatment of monies paid to third parties as a proxy for alimony, less relevant. For pre-2019 divorce and separation agreements, the alimony is deductible to the payor and includible in income to the recipient.
The TCJA effectively made the dependency negotiating point between spouses moot. From 2018 to 2025, there is no deduction for dependency; beginning in 2026, however, this deduction will become effective once again. Thus, if a taxpayer is going through a divorce in 2021 and the children are young, this is an area one may want to address in any agreement that determines who receives the dependency deduction in 2026 and beyond. Tax law governs who gets the exemption, and it’s always the spouse who has legal custody; a divorce or separation agreement does not override federal tax law. Therefore, an agreement can certainly be made between the spouses as to who takes the dependency exemption deduction. If the noncustodial parent gets the deduction per an agreement, then the only way the federal law allows the noncustodial parent to take the exemption is by the custodial parent signing IRS form 8332, a copy of which should be provided to the noncustodial parent. It is good practice to spell this out in agreements to ensure the custodial parent has accountability, in order to facilitate the execution of this document.
Whether an agreement is pre- or post-2019 has no bearing on whether or not child support is taxable; it is not taxable, nor is it deductible. If a pre-2019 agreement calls for unallocated child support and alimony, however, then it is includible in income in full and deductible to the payor in full. A qualifier to this would be if the unallocated amounts were reduced by a child reaching age 18; then by rights, that portion of the unallocated support is really not unallocated. That portion is really child support and should be treated as if it is not deductible and not taxable.
Property settlements are nontaxable events. To the extent that property or stock is transferred, the receiving spouse retains the cost basis. When a couple divorces, it must consider not just the transfer of the equitable fair market value (FMV) of the stock, but its cost basis as well. For example, consider a couple that owns 2,000 shares of GE stock worth $70,000. The cost basis in those shares vary. Assume 1,000 of those shares have a cost basis of $8, and 1,000 have a cost basis of $30. Also assume the agreement calls for a split of these assets between the spouses. On the surface, one might simply transfer 1,000 shares to the other spouse. Assume the husband transferred 1,000 of those shares but only using the $8 cost basis stock. The following compares this approach with an alternative wherein the cost basis is equally split:
|Scenario 1—Husband Transfers Low Basis Stock|
|FMV of shares transferred||$35,000||$35,000|
|Cost basis of shares transferred||30,000||8,000|
|Taxable gain upon sale||$5,000||$27,000|
|Scenario 2—Husband Transfers Shares Equal Cost Basis|
|FMV of shares transferred||$35,000||$35,000|
|Cost basis of shares transferred||19,000||19,000|
|Taxable gain upon sale||$16,000||$16,000|
As is illustrated above, the transfer of cost basis is equally as important as the FMV. Advisors should carefully review property settlements with an attorney in order to ensure fairness occurs within the distribution of assets.
Sale of Residence
Under IRC section 121, a couple selling its home can generally exclude up to $500,000 of gain from the sale of a primary residence. It is common that one spouse moves out and the other retains the house, even if the departing spouse still owns title on the home. In such a case, language should be included in the agreement to protect the departing spouse who moves out to exclude $250,000 of the gain.
These are often the most difficult assets to address in a divorce. Often, one spouse is undervaluing the business interest, whereas the other spouse is overvaluing the interest. Typically, the spouse who is active in the business will retain ownership and the spouse who is not active will be compensated by splitting other assets. This can be a complicated process; for example, the transfer of partnership interests includes the reduction of recourse debt and built-in gains that can trigger adverse tax consequences.
The splitting of assets in a divorce often involves a pension, 401(k), or IRA. A qualified domestic relations order (QDRO) gives a spouse a right to share in the qualified nature of the account (meaning tax deferred, as if the spouse was the owner). Without a QDRO, this benefit cannot be received.
A common area to review when consulting wealthier clients is any “kiddie tax” issue. In short, the kiddie tax occurs when a child’s investment income is taxed at a parent’s higher rate. Spouses need to share information in order to calculate and pay the kiddie tax or plan ahead, if possible, to minimize the impact.
A very common feature in divorce cases is the need to completely restructure the estate planning and will. Custody matters, new property ownership, trustee changes, and life insurance beneficiaries are common items that change in a divorce.
Start at the Beginning
There are many tax factors to consider in a divorce; this article has only touched upon some of the most common ones. The first step is a complete overview of the client’s assets, liabilities, and income. CPAs are not attorneys, and family law attorneys don’t practice tax. But by working together, professionals can be effective in ensuring that a desirable outcome for all parties is achieved.