Some Tax Aspects of Divorce

Taxes and Divorce:  Alimony, Child Support, and the Property Settlement

For better or worse, divorce is one of those life stages that an awful lot of us pass through at one time or another.  There is, after all, roughly one divorce for every two U.S. marriages.  It’s a tough time, sure, but also a time of hope and new beginnings.  It has tax aspects, too, and that’s one of the pieces determining how well you and your loved ones come through it.

First, consider the property settlement.  The basic rule is that when couples divide their property incident to a divorce (either within one year of the event itself and perhaps later if “related to the cessation of the marriage”), no one recognizes gain or loss for tax purposes.  Still, one goal is to split things up more or less evenly, at least from a dollars and cents point of view, and sooner or later all that divided property will be sold.  So reaching an equitable settlement should mean considering the after tax values of the property being divided.

For instance, suppose our disillusioned couple, preparing to separate, own:

  • a house (fair market value of $350,000 and purchased five years ago for $400,000
  • A business generating $75,000 of distributable income each year
  • two cars, more or less equal in value
  • 100 shares of XYZ stock (fair market value of $100,000 and purchased six months ago for $80,000)
  • Cash or cash equivalents of $60,000
  • Assorted household and personal items having smaller, miscellaneous values

Suppose all this property were divided, on paper, into two groups.  One way to decide if this settlement was equitable is to ask this question:  If all the property were sold on the effective date of the settlement (or some other mutually agreeable date) how much cash would each party have?

The gross selling prices wouldn’t be of much use answering that question.  Selling the family home, for example, would yield a$50,000 loss but no tax deduction.  The stock would give a $20,000 gain subject to the short-term capital gains tax rate.  Valuing the business would be especially tricky, needing an actuary’s touch to discount a future income stream, and adjust it for risk, blood, sweat, and tears, and taxes.

This after-tax valuation would, of course, be just a starting point.  One party may want the house more, or the business less.  None-the-less, there’s a demonstrable, numerical sense of fairness to be had by showing that, on a net, after-tax basis, each person’s pile of stuff is worth about the same amount of present-valued dollars.

Next, it’s entirely possible that our hypothetical couple has a marriage where one or them will be paying alimony and child support to the other.  Alimony is taxable income to the recipient and a tax deduction for the payer.  The fact that the recipient’s effective alimony income is reduced by taxes can lead to negotiations in which the terms of the property settlement are adjusted in exchange for larger first and second year alimony payments.

The parties are certainly allowed to negotiate their divorce as they see fit but there is a trap lurking here for the unwary.  The IRS has a test, applicable to the first two years of alimony payments.  During those two years the payer will have deducted his larger alimony payments (larger payments, presumably, in exchange for keeping a larger share of the divided property).  The IRS test will compare those larger early payments to that made in the third year.  If the computation reveals “excess” amounts, that excess is added back to the payer’s third year income and subjected to tax.

Finally, although child support payments are typically set by statute higher income individuals may well run off the end of the tables and need to negotiate additional amounts.  Even payers entirely subject to the tables may be willing to make additional, targeted payments in support of the child in the hopes of meeting specific needs.  But unlike alimony, child support payments cannot be deducted by the payer and the recipient-parent need not report them as income.

This means the payer has an incentive to characterize more of his or her total payments as “alimony” while the recipient is better off seeing them called “child support”.  It turns out the parents have some leeway here to negotiate the split since, where the alimony agreement calls for specific portions of the payments to be spent on the child, the IRS will usually treat the additional payments as nondeductible child support payments, even if the family court characterized them otherwise.

Divorce is as major a life event as marriage or the birth of children.  You have retained an attorney, mediator, or other family law expert to make sure it goes as smoothly as possible.  Before signing on that bottom line, though, make sure that the tax aspects have all been addressed.

This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.