Getting Divorced? Here are Some Tax Traps to Avoid.

Divorce is tough. No doubt about it. So avoiding more bad news is probably a good idea. While I can’t make divorce any easier here are some tips on avoiding tax troubles in your divorce:

1. Filing a joint return in your final year of marriage.

The instinct that often prevails during divorce is to file as married filing jointly one last time. The reason is that most separating couples want to take advantage of the lower tax liability and the availability of certain credits one last time. There is a downside, however. Filing a joint return makes you liable, jointly and severally, with your soon-to-be ex-spouse. That means the IRS can come after you for the full amount of the tax liability shown on the return or if additional taxes are assessed after a later audit.

By filing a joint return, the IRS now has the right to collect all of the tax debt from both of you, even if the source of the liability was your ex-spouse. For example, you have a regular job but your husband is self-employed and he took deductions he shouldn’t have. The IRS later audits the return and assesses additional taxes. Now you are on the hook for those additional taxes. What’s worse is that even if the divorce judgment allocates a tax debt between you and your ex-spouse the IRS does not need to honor it because Federal law trumps state law. The better course of action may be to file married filing separately in certain cases. The takeaway here is don’t just assume that filing jointly is the way to go merely because it means you have to pay less taxes overall. Speak with your accountant first.

2. Alimony recapture.

The IRS has a quirky rule regarding alimony. If you are required to pay alimony to your ex-spouse and your payments decrease within the first three years following your divorce than you might run into some tax trouble. Normally, alimony payments are taxable to the recipient and deductible by the payer but where the alimony recapture rules apply than the payer may have to report some portion of those alimony payments as income in the third year.

The rules for alimony recapture are a bit complicated to explain in a blog post but watch out for the following situations which may indicate you have an alimony recapture problem: (1) there is a change in your divorce judgment, reducing payments; (2) you fail to make your alimony payments timely; (3) there is a reduction in either your ability to pay the alimony or in your ex-spouse’s need for alimony payments. If you find yourself in one of these situations you may want to talk with your accountant to determine if you may have to pay some unexpected taxes to Uncle Sam.

3. Dividing an individual retirement account.

Many marital estates contain a retirement plan that has to be divided, usually in the form of individual retirement accounts or IRAs. Unlike 401ks or a military pensions, IRAs do not require a special order from the court (called a qualified domestic relations order or QDRO) for the IRA to divided between the parties. This ease of transfer is, of course, a trap for the unwary. While no court order is required to divide your IRA it does not mean that you can simply write a check to your ex-spouse from your IRA and the matter is done. No, nothing is quite that easy in life or taxes. The IRS has specific guidance on how the IRA is to be divided.

To accomplish the transfer, the IRA must be divided among the divorcing couple under a divorce or separation instrument, which means the IRA should be divided in the divorce judgment or through a written agreement between the parties. Once that is done then the IRA must be transferred by a direct trustee-to-trustee transfer. If you take the money out of the account and transfer it then transfer is treated as a taxable distribution. Which means that the recipient spouse must set up his or her own IRA and provide instructions to the IRA trustee to make a proper transfer. If 100% of the IRA is going to be transferred than the owner merely needs to have the name changed.

Failure to follow these procedures may mean you may be facing additional income taxes and an early withdrawal penalties (10%) on the amount transferred.

4. Not considering the tax consequences of a property division.

Property divided in a divorce does not trigger a taxable event and so property can be freely transferred between divorcing spouses. Again, while this all sounds good, this is a trap for the unwary. Just because you can transfer property among divorcing spouses tax free does not mean that it is without tax consequences.

Consider the following. A couple has two jointly assets to divide: stocks worth $100,000 (with a tax basis of $50,000) and $100,000 in cash. The husband wants the stocks while the wife wants the cash. After the divorce is finalized, the husband changes his mind about keeping the stock and sells the whole lot for $100,000. Come tax time the husband gets a surprise when he has to pay taxes on the gain from the sale of the stock ($100,000 less $50,000 basis equals a gain of $50,000). So while his wife got $100,000 in cash, he will only receive whatever is left over after paying taxes (which is certainly less than $100,000). Laughing all the way to the bank, the ex-wife owes no taxes on her $100,000 in cash because cash has a basis equal to its face value ($100,000) while other property may have a basis that is less than fair market value, especially where you purchase appreciating property like stocks and collectibles. Changing hands does not increase the basis to fair market value because it was a tax free transfer.

Now let’s say the couple gets cute and decides to have the wife “sell” her interest in the stock to her husband in exchange for cash. Sadly, that will not work either as transfers, to include sales, are not taxable between spouses for a period of time after the divorce (while this presumption doesn’t go on forever, it goes for a number of years after divorce). So pay attention to the potential tax consequences of dividing up your marital property, there may be hidden taxes due!

5. Marital status.

Finally, the issue of marital status comes up quite frequently. Many divorcing couples believe that if they are separated (but not divorced) at the end of the tax year than they can choose the tax status that provides the most benefit, usually head of household. The reason for this is obvious: married filing separately has restrictions on the credits that can be taken, such as the child care credit, education credits and earned income credit. All of which can have a big impact on your taxes.

Your tax status is determined by your married status as of December 31. If you are still married at year-end than you cannot file single and there are restrictions on filing head of household. For the most part, you must file married filing joint or married filing separate. To be able to claim head of household the taxpayer must meet the strict requirements of the statute. Again, if you are not divorced at year end, speak with your accountant to determine what filing status’ are available to you.