Couples going through a divorce know that change is inevitable and planning essential, especially when it comes to finances. With tax laws constantly changing, many are caught by surprise when they file their first post-divorce tax return, only to realize they failed to consider an important tax item.
Below are a few tax curveballs you could encounter in your first post-divorce return. Divorcing couples, especially those with children, should discuss these issues ahead of time to avoid a financial strike-out.
Child Tax Credit
The American Rescue Plan (ARP) brought changes to the child tax credit that could translate into thousands of dollars, depending on your situation.
The child tax credit is refundable, which means the claiming party does not have to report income or owe any tax to receive their eligible amount. Credits are worth up to $3,600 for children under 6 and $3,000 for children between ages 6 and 17. The claiming parent must provide over 50 percent of the expenses of the qualifying child, who must also live for them for at least half of the year—but ex-spouses are allowed to transfer this write-off to the noncustodial parent by filling out Form 8332.
As if tax laws weren’t complicated enough, the ARP also provided for advance payments of the child tax credit for the last six months of 2021. There’s one caveat—the advances were based on IRS estimates of the taxpayer’s 2021 income, which created a problem for taxpayers who made more money than the IRS estimate. In those cases, the taxpayer was eligible for less and likely overpaid by the IRS. What many people fail to realize is that this excess credit must be paid back.
Divorcing couples should share information early about any credits received throughout the year and reach an agreement on how these credits will be reported and, if necessary, repaid. The IRS has a record of payments made, so these amounts must be correctly reported on the return to avoid triggering an audit.
Many divorcing couples do not realize that the Tax Cuts and Jobs Act of 2017 eliminated the paying spouse’s ability to deduct alimony in divorces finalized after 2018. This also means that the receiving spouse no longer has to claim the alimony as income.
Unfortunately, not everyone is not aware of this change, and payers of alimony in post-2018 divorces may find that they owe more in taxes than they anticipated.
Property transfers in a divorce, such as those for investment accounts and real property, are nontaxable events. However, even though the transfers are nontaxable, there could be significant tax consequences later when transferred assets are sold.
When stock is transferred from one spouse to another in a divorce, the existing cost basis transfers with the stock. During settlement negotiations, many couples fail to consider basis and instead focus only on fair market value. If stock with a low basis is later sold, the selling party will owe tax on any capital gains, which could be significant.
Basis is also important when dividing real property. The IRS allows a $500,000 exclusion of capital gains for married couples who sell their residence if certain conditions are met. For single filers, this is exclusion is limited to $250,000.
When the spouse of the individual making the transfer is a nonresident alien, however, the transferor must recognize gain at the time of transfer. Once the transfer is made, the nonresident spouse will receive stepped-up basis in the property.
A financial expert can help the divorcing couple determine whether to divide, transfer, or sell property based on their unique financial situation.
Dividing a community-owned business can be tricky. In many cases, a business valuation expert is brought in early to value the business, which is determined by many factors.
For example, a service business may not have many physical assets, which can make it difficult for the couple to value. Additionally, the transfer of partnership assets may involve a reduction in recourse debt or built-in gains with potentially large tax consequences. A business valuation expert will carefully review the company financials and apply approved valuation methods to arrive at a calculated value. A financial expert will assess the tax impact of the transaction on the overall settlement.
If the appropriate experts are not engaged, the business may be over- or undervalued and an important tax consideration overlooked. The result could be an inequitable division of property or an undesirable future tax consequence for one of the parties.
There are hidden tax consequences in many decisions made by divorcing couples during settlement negotiations. Those who engage a financial expert can step into their post-divorce lives with the assurance that they have considered all current and future tax consequences of their decisions.
While Hoffman Divorce Strategies does not prepare tax returns or give tax advice, we work with divorcing couples, their counsel and tax preparers to assist you in navigating tax issues unique to a divorcing couple. Contact us to see how we can help.