Watch For Tax Angles In A Divorce Agreement

This week’s post is by Wendy Knutson, CPA.

If you’re getting a divorce, you’ll have to work through a variety of financial issues governed by prevailing state law. But don’t overlook the federal income tax implications. Advance planning can be critical in the following areas:

Alimony vs. child support. Generally, payments designated as alimony in a divorce decree are deductible by the payer and taxable to the recipient. But the opposite is true for child support; the payments can’t be deducted by the payer and are tax-free to the recipient. Make sure that the decree accurately reflects your intentions.

Filing status. If you divorce before year-end, you must file your 2012 federal income tax return as an unmarried individual. Depending on your situation, you may fare better or worse as an unmarried filer. For instance, joint filers could be hurt by the “marriage penalty” if the income of the spouses are relatively equal. In that case, it may be advantageous to finalize the divorce before year-end.

Dependency exemptions. Generally, the parent who has custody of young children for most of the year is the one entitled to dependency exemptions for the children. However, a noncustodial parent may claim the exemptions if the custodial parent signs a formal waiver.

Division of property. Property transferred incident to a divorce is tax-free to the recipient. The recipient’s basis and holding period are the same as they were for the ex-spouse. If you receive property in a divorce and then sell it, you must report the realized gain or loss on your tax return.

Other special tax rules may apply to the sale of a principal residence, IRA and retirement plan benefits, and life insurance policies. In summary: Seek expert tax guidance throughout the divorce proceedings to protect your financial welfare.

Your Functional Divorce Assignment:

If you’ve got questions about taxes, give a CPA a call.