As the saying goes, “nothing is certain except for death and taxes.” However, prudent tax planning can reduce the bite of the tax collector. Parties going through a divorce can reduce their tax liability by taking advantage of some very basic tax strategies.
Believe it or not, something as simple as deciding when to go to court to make a divorce final can be the most important tax consideration. Parties who are divorced by December 31st of the tax year in question will not be able to file joint income tax returns. In most cases, being able to file under the status “married filing jointly” will result in substantial tax savings. This is because of the favored tax rates extended to married couples. For example, in 2015 a single filer earning $74,900.00 will be in the 25% tax bracket, where the same income under the married filing joint tax status is taxed at only the 15% bracket. In such a case, divorcing couples may save themselves thousands of dollars by merely delaying entry of a divorce from December to January. Divorcing couples should consult with their accountants for guidance on the best filing status and whether delaying the entry of the divorce until the New Year makes sense.
If one party to a divorce will be receiving alimony, this will also present an opportunity for tax planning. Generally, alimony is taxable as income to the recipient and fully deductible by the payor. In other words, if one party receives $50,000.00 per year in alimony, that spouse will need to claim that $50,000.00 on his or her income tax returns and pay taxes on that amount. On the other hand, the party who pays $50,000.00 per year in alimony will be able to deduct that $50,000.00 from his or her total taxable income, thereby reducing that party’s tax liability. Understanding what alimony will actually cost the payor on an after tax basis – and what the recipient will net on an after tax basis – is essential. For example, if the party deducting the alimony is in the 33% tax bracket, while the party claiming alimony is only in the 25% tax bracket, it may cost the payor only 66 cents ($1.00 – .33 = .66) for the recipient to receive 75 cents ($1.00 – .25 = .75). Having this knowledge allows for significant tax savings and the opportunity to structure an alimony award in a way that can be a “win-win” for the parties.
Another tax issue to be addressed by divorcing couples who have children is the claiming of the children as dependent exemptions. Claiming a child or children as a dependent exemption(s) for income tax purposes can result in substantial tax savings. In 2015, the dependent exemption increases to $4,000.00 per child. Parties need to discuss with their respective attorneys and tax advisors which party will claim each child as a dependent exemption following their divorce. It is not required that the party who has physical custody of the child must claim the child as a dependent exemption. Indeed, it may make for a greater tax savings to negotiate a settlement whereby the party with the higher income gets to claim the child.
Parties should be aware of tax issues resulting from something as basic as what will happen to the jointly owned marital home. A marital home which has an unrealized gain of $500,000 (for example, say a home purchased 10 years ago for $300,000 is now worth $800,000), could result in thousands of dollars in tax liability if transferred to one party and then sold after the divorce. If this same home was sold jointly by the parties incident to the divorce, no tax would be owed due to the capital gain exclusion (currently $250,000 per person).
The above-referenced examples are only a few of the many tax considerations that arise in connection with a divorce. Yes, taxes are inevitable, even for divorcing couples. However, properly taking advantage of some basic tax strategies during the course of a divorce can save the parties substantial tax dollars.