Divorce and Taxes: Issue #4. Property Transfers

In any divorce where the parties own assets of value, there will likely be some transfer of assets between the parties as part of the divorce settlement. Assets that could be at issue range from tangible personal property (i.e. the pots and pans) to bank, investment and retirement accounts. In addition, the most valuable asset in many marriages is the marital home (and/or other real property). Although generally tax implications in spousal transfers are minimal there are some issues to look out for.

Issue #4. PROPERTY TRANSFERS: Because some assets are post-tax (such as bank accounts) and some assets are pre-tax (such as retirement accounts or capital gains), it is important to understand the tax implications in dividing them. If you trade a pre-tax asset for a post-tax asset of equal value without taking into account the resulting tax liability then you've lost the value of the tax liability. Therefore it is important to understand which assets have tax liability associated with them and whether there are any tax liabilities created through transfer.

PERSONAL PROPERTY WITHOUT CAPITAL GAINS: The transfer of personal property and bank accounts is simple. These items do not typically have any tax basis or capital gains upon transfer or sale because their value is either minor, depreciated, or, in the case of bank accounts, the appreciation is minimal.

PERSONAL PROPERTY WITH CAPITAL GAINS: Similarly, the transfer of property assets with capital gains implications is relatively simple. Pursuant to § 1041(a) of the Internal Revenue Code transfers to a spouse do not result in a gain or loss. This is also true for transfers to a former spouse if the transfer is incident to a divorce. This means that a stock transfered to a spouse or former spouse will maintain the same capital gains characteristics (and tax liabilities) as it would have had in the original spouse's possession. This is also true for an investment account, collectible, or house.

RESIDENTIAL REAL PROPERTY: In the case of residential real property there is a potential benefit to selling the house while still married instead of transferring it between spouses. There is a capital gains exclusion for profits realized on the sale of a residence and it is doubled for spouses. If the parties divorce and one party transfers their interest to the other, and that former spouse then later sells their interest in the residence they will only have the single capital gains exclusion. Of course, this only matters if there is significant equity in the residence.

RETIREMENT ACCOUNTS: Retirement accounts are not typically transferable between anyone, even spouses, without tax consequences. In order to transfer funds held in a retirement account the owner must first remove them from the retirement account, which, if allowed by the rules of the plan, will result in taxable income and, prior to retirement age, tax penalties. However, in the event of a divorce the IRS allows a one-time transfer by Qualified Domestic Relations Order (also known as a "QDRO"). A transfer of retirement account between former spouses pursuant to a QDRO results in a new retirement account held in the name of the other spouse in the amounts and per the terms specified in the QDRO. The retirement income paid from said account will be taxable income upon receipt just as it would have been to the original owner.

Click here to read Divorce and Taxes: Issue #5. Joint Tax Liability.

Does Reducing and Limiting Alimony Force Primary Caretakers into the Workforce?

When a child is born out of wedlock, either parent may initiate a court proceeding to establish certain rights and obligations that come with raising a child. Such rights include visitation, the ability to make significant life decisions for the child, and child support. The purpose of child support is to provide a measure of financial security for a child from a parent that might not be living with the child full-time.

When a child is born into a marriage that later dissolves, child support may be ordered, and usually is. The purpose of child support for children born into a marriage, or out of wedlock, is identical: to provide for the financial costs of raising a child.

However, when marriages dissolve, the finances of the couple might be such that a court will order alimony as well. The purpose of alimony is to provide for the financial well-being of a former spouse. The issue of alimony always has been, and will likely always be, controversial. The rationale behind it is that in a marriage, both people contribute in (ideally) complementary ways. When one spouse devotes time to furthering his or her career, it is (ideally) with the contribution of support from the other spouse. For example, if one spouse is picking up extra hours at work to get a promotion, he or she is doing so while his or her spouse is taking care of the home, or the kids. Often times, one spouse is not as able to further his or her career while their partner does. When the marriage dissolves, courts want the spouse who was not as able to further his or her career to smoothly transition into a financially independent unit, and the tool through which this is accomplished is alimony.

In Massachusetts, alimony is still officially a matter of great discretion for judges. The Alimony Reform Act of 2011 does not become effective until March 1, 2012, although many judges are issuing orders consistent with its new limits. The Act, for the first time in Massachusetts, creates a formula for calculating alimony, much like the existing child support guidelines in Massachusetts. One of the more important provisions of the Alimony Reform Act is that no income included in the calculation of child support will be then included in a calculation of alimony. The child support guidelines in Massachusetts are limited to a combined income of $250,000. Thus, unless the combined income in a marriage where there are minor children is more than $250,000, absent circumstances that would convince a judge to vary from the formulas, there will be only child support and no alimony order (provided that the lesser earning spouse is the primary caretaker of the minor child or children -- judges still have a good deal of discretion, and I would encourage you to speak to an attorney if you have any questions or concerns about your specific case).

This muddies the waters a bit from the varying justifications for child support (provide for the child) and alimony (provide for the former spouse). One justification for this is attrition. For couples earning less than $250,000 combined, there is usually not enough income to justify both child support and alimony. What the court will label as "child support" (and the IRS and Department of Revenue will treat as "child support") does assist the primary caretaker into transitioning into a financially independent unit.

However, it is not enough to provide for the economic quality of life enjoyed during the marriage. When a couple divorces, the expenses once shared (one home, one electricity bill, etc.) are now separated. Now there are two homes to pay for, and two electricity bills. Even if the combined income stays the same, the combined expenses will increase. For many individuals, receiving child support will not be enough. They will need to transition back into the workforce, or focus more time on increasing their income to meet their expenses. The "child support" will provide a measure of financial security to the recipient spouse as he or she transitions to devoting more energy towards furthering his or her career. This, unfortunately, comes at the cost (usually) of spending time at home with the children.

What is a QDRO?

QDRO stands for Qualified Domestic Relations Order, and they are the vehicle by which retirement assets are transferred post-divorce.

Retirement accounts are not typically transferable between anyone, even spouses, without tax consequences. In order to transfer funds held in a retirement account the owner must first remove them from the retirement account, which, if allowed by the rules of the plan, will result in taxable income and, prior to retirement age, tax penalties.

However, in the event of a divorce the IRS allows for a one-time transfer by Qualified Domestic Relations Order (also known as a "QDRO") to avoid these taxes and penalties. A transfer of retirement account between former spouses pursuant to a QDRO results in a new retirement account held in the name of the other spouse (or "alternate payee") in the amounts and per the terms specified in the QDRO. The retirement income paid from said account will be taxable income upon receipt just as it would have been to the original owner, but the transfer between spouses is not taxed at the time of the transfer.

The Fight for Gay Marriage and Gay Divorce

As described in a recent article on CNN Living (Serious legal hurdles for gay divorce), just because gay and lesbians can get married doesn't mean they can get divorced.

Gay and Lesbian couples who marry in one of the few states that allow gay marriage may not be able to get divorced if they move to another state. Currently only Massachusetts, Iowa, Connecticut, New Hampshire, Vermont, and the District of Columbia issue marriage licenses to same-sex couples.

As the CNN article describes, the Texas Attorney General is appealing a ruling by a Texas Judge allowing a lesbian couple (who had been married in Massachusetts) to get a divorce in Texas. An attorney who represents a gay couple awaiting the Texas decision noted "Ironically, if the attorney general [of Texas] is so against gay marriage, why is he trying to hard to keep these two men together?"

Regardless of the ruling in that case, getting divorced in other states isn't the only hurtle facing gay and lesbian couples who want a divorce. DOMA, the Defense of Marriage Act, denies same-sex spouses access to many federal benefits. In a same-sex divorce case, even in Massachusetts, the couple will not be able to accomplish certain typical divorce resolutions in the same way as an opposite sex couple.

For example, a typical division of an asset in a divorce is to transfer a portion of one party's retirement asset to the other. This can be accomplished without tax consequences via a Qualified Domestic Relations Order, but since the IRS does not recognize same-sex marriage, this same transfer would have significant tax consequences in a same-sex divorce. Another example is the tax treatment of alimony. The payment of alimony by the payor to the recipient is taxable to the recipient and tax deductible to the payor. This allows for a shifting of the tax burden, and also usually for a lower tax burden overall because some of the income is shifted to a lower tax bracket. Again because the IRS does not recognize same-sex marriages, same-sex couples who have an alimony order will not receive this tax benefit.

For a further description of how DOMA affects same-sex marriages and the current cases challenging it ( ) check out this article written by our Law Clerk, Jonathan R. Eaton: Defense of Marriage Act: Ability of the Federal Government to Deny Access to Benefits to Spouses in Same-Sex Marriages.

Divorce and Taxes: Issue #5. Joint Tax Liability

Issues 1 through 4 all focus on the tax liabilities created post-divorce. But what about tax liability incurred during the marriage?

Issue #5. JOINT TAX LIABILITY: The Court has the power in a divorce case to assign both assets and liabilities, including tax liability incurred during the marriage. If there are joint tax returns filed during the marriage for which taxes are still owed, that liability is owed by both parties to the taxing authorities. The Court may assign that debt to one party by order or agreement, but that doesn't always satisfy the taxing authorities.

Unless you file an innocent spouse application with the IRS (and the IRS makes an innocent spouse determination in your favor), they will still consider a joint debt owed by both parties until satisfied. A probate court order allows you to collect against your former spouse but does not prevent the IRS from collecting against you. Therefore, if there are any assets available for the payment of tax debt at the time of divorce, paying the debt off immediately is recommended.

We also recommend including language in any settlement agreement to deal with the possibility of an audit that assigns debt on a joint return that was previously considered satisfied:

"For the years of the marriage (__________ to __________), if there is a deficiency assessed in connection with any joint federal or state income tax returns heretofore or hereafter filed, or if any other notice is received by either Party relating to any Federal or State tax, interest or penalty claim, the Party notified thereof shall forthwith notify the other Party immediately in writing. Each Party, on account of whose net income a deficiency is assessed, shall pay the amount ultimately determined to be due thereon with respect to his or her net income, together with interest and penalties, and shall pay as well any and all expenses that may be incurred if he or she shall decide to contest the assessment.

In the event that the deficiency is assessed with respect to joint income, each shall pay the deficiencies and expenses in the same proportion as each Party actually received the said gross income for the calendar year in which the deficiencies and expenses are assessed. For purposes of this EXHIBIT “gross income” shall be defined in accordance with the applicable provisions of the Internal Revenue Code of 1986 and in accordance with the applicable provisions of the Massachusetts Child Support Guidelines.

Each Party shall keep the other fully informed of any and all steps taken by him or her with respect to any deficiency assessment. The Party whose actions are responsible for the deficiency, if any, shall in all respects indemnify the other against and hold him or her harmless from any deficiency assessment or tax lien arising out of any joint return heretofore or hereafter filed by the Parties, as well as any damages and expenses whatsoever made in connection therewith including reasonable attorney's fees and costs."

Click here to read Divorce and Taxes: Issue #6. Same Sex Marriages.

Child Tax Deductions: Who gets them in a Divorce?

On your Federal Income Tax Return you can claim an exemption for each qualifying child, which for the tax year 2011 will result in a $3,700 per dependent credit off of your taxable income.  Depending on your tax bracket this could save you as much as $1,295 in federal taxes.

But if you are separated or divorced and filing separate federal income tax returns, who gets the exemption?

First of all, you can't both take it.  Only one of the parents can use the exemption for each child on their return. If you both claim a child, the IRS will reject your return and send you a letter indicating that you must amend.

So which one of the parents gets to use the exemption?

Pursuant to IRS Publication 501, the IRS considers a child of divorced or separated parents in most cases to be the qualifying child of the custodial parent only.  The IRS defines custodial parent as "the parent with whom the child lived for the greater number of nights during the year. The other parent is the noncustodial parent."

It doesn't matter if your agreement says you share custody.  If one parent has the child more than 50% of the time, then that parent is the custodial parent as far as the IRS is concerned.  ("If the child lived with each parent for an equal number of nights during the year, the custodial parent is the parent with the higher adjusted gross income (AGI).")

It is possible, though, to transfer the exemption from the "custodial" parent to the "noncustodial" parent.  Some division of this benefit is often negotiated as part of a divorce agreement or ordered by a Judge, to give the noncustodial parent some tax credit in exchange for the child support that they pay from post-tax income.  In the case of one child, the exemption can be alternated from year to year, or when there are multiple children the exemptions can be divided between parents.

In order for this transfer to be allowed by the IRS, certain rules must be complied with.  According to Publication 501, a child can be treated as the qualifying child of the noncustodial parent if four requirements are satisfied:

1. The parents are divorced or legally separated under a decree of divorce or separate maintenance, the parents are separated under a written separation agreement, or lived apart at all times during the last 6 months of the year, whether or not they are or were married;
2. The child received over half of his or her support for the year from the parents;
3. The child is in the custody of one or both parents for more than half of the year; and
4. The custodial parent signs a written declaration,  Form 8332, that he or she will not claim the child as a dependent for the year, and the noncustodial parent attaches this written declaration to his or her return. (For cases prior to 2008 this requirement is slightly different and you should review Publication 501 further).

If you have a divorce agreement that states that the non-custodial parent gets the child's tax exemption, then Form 8332 must be completed or the IRS could reject the return.  If the custodial parent refuses to sign Form 8332 then you must file a Complaint for Contempt with the Probate & Family Court.  The IRS will not honor the divorce agreement without a signed form 8332.

Visit our site for more information on how to file a Complaint for Contempt.