Published on October 20, 2007
Tax Issues in Divorce: Traps for the Unwary! Brian C. Vertz, Esq., MBA, AVA BVSource.com Pittsburgh
Syllabus Alimony – 15 minutes Taxpayer Filing Status, Deductions, Exemptions and Credits – 10 minutes Marital and Community Property – 15 minutes Food for Thought – 5 minutes
Alimony IRC § 71 – Alimony is taxable to recipient IRC § 215 – Alimony is deductible to payor 8 Elements of Deductibility BVSource.com
Alimony: 8 Elements of Deductibility Payment must be made in cash 1. Written order or agreement 2. Not designated as non-deductible 3. Spouses not living together 4. Must terminate upon payee’s death 5. Must not be designated as child support 6. Spouses must not file joint tax return 7. Must not be front loaded 8. BVSource.com
Third Party Payments Must benefit the alimony recipient Rent, tuition, auto loan, credit cards Payments on a joint mortgage loan ½ alimony (payor pays recipient’s share) ½ not alimony (payor pays own share) Conflict with mortgage interest deduction? Utilities (even if joint) Life insurance (if recipient is owner) BVSource.com
Arrears and Voluntary Payments Is a letter an agreement? Voluntary increase or extension of alimony Payments made after support action is filed but before an order is entered Arrears paid according to order or agreement Agreement to recharacterize arrears BVSource.com
Imputed Child Support Termination or modification of alimony within 6 months of a child turning 18 or 21 or local age of majority Modification on 2 or more occasions that are within 1 year of a different child attaining a certain age between 18 and 24 BVSource.com
Illustration: Imputed Child Support 1/1/1991 1/1/1995 First Reduction Date Second Reduction Date Child’s Carl David Carl David Ages 20 yrs, 5 mo 18 yrs, 3 mo 24 yrs, 5 mo 22 yrs, 3 mo 1 year 19 yrs 21 yrs 17 yrs 19 yrs 23 yrs 25 yrs 21 yrs 23 yrs after/ 5 mo 5 mo 3 mo 3 mo 5 mo 5 mo 3 mo 3 mo prior Midpoint – 21 yrs, 4 months Less than one year apart for each
Using Allocation to Settle Cases Alimony shifts tax burden from higher tax bracket to lower tax bracket Keeps more money “on the table” BVSource.com
Unallocated Alimony/Child Support Imputed child support rules Pivotal question: would payment continue after death of custodial parent? Language of order or agreement State support statute Abatement of divorce action BVSource.com
Termination Upon Death Johanson v. Com, T.C. Memo 2006-115 Marital settlement agreement silent California law: “spousal support” terminates upon payee’s death BVSource.com
Termination Upon Death II Kean v. Com, 407 F.3d 186 (3d Cir. 2005) Support order silent New Jersey law silent New Jersey law: divorce abates upon death of a spouse BVSource.com
Kean v. Com. “Where support payments are unallocated, as in this case, the entire amount is attributable to the payee spouse’s income. Otherwise, we would be left with a situation in which the portion of the unallocated payment intended for the support of the payee spouse would be taxable to the payor spouse. This treatment of support payments is not accidental, and can benefit families going through a divorce. “By ordering the payor spouse to make an unallocated support payment taxable in full to the payee spouse, the couple may be able to shift a greater portion of their collective income into a lower tax bracket. Consequently, an unallocated payment order not only frees the parents from restrictive court instructions that dictate who pays for what, but may allow the parties to enjoy a tax benefit at a time when they face increased expenses as they establish independent homes. This advantage would be lost by taxing all unallocated payments to the payor spouse.” BVSource.com
Alimony Recapture Prevents divorcing spouses from disguising their property settlements as tax-deductible alimony Does not apply to temporary support No recapture if: Y2 ≥ Y1 - $7,500 ….and Y3 ≥ Y2 - $15,000 BVSource.com
Legal Fees Salesky - T.C. Memo 2006-162 Court ordered Husband to pay CF directly to Wife’s law firm Husband claimed alimony deduction NJ law: Obligation to pay CF terminates upon death of payee Not tax-deductible BVSource.com
Resources Publication 504, “Divorced or Separated Individuals” Frumkes on Divorce Taxation Marjorie O’Connell, Divorce Taxation CCH Family Law Tax Guide BVSource.com
Taxpayer Filing Status, Deductions, Exemptions and Credits Qualifying as Head of Household Separated Parents: Who Gets the Dependency Exemptions and Tax Credits Separated Homeowners: Who Gets the Deductions BVSource.com
Head of Household Must be divorced or separated 6 months Must pay at least ½ cost of housing Must have custody at least ½ of time Must be eligible to claim dependency exemption (even if assigned to other parent) BVSource.com
Married Filing Jointly Can aggregate certain deductions No alimony deduction Phase out of deductions Hazard: joint liability Innocent Spouse Relief Separation of Liabilities Equitable Relief BVSource.com
Dependency Exemption Five Tests: Relationship Age Citizenship/Residency Principal Place of Abode Support IRS Form 8332 BVSource.com
Credits Child Tax Credit Child Care Tax Credit Earned Income Credit Tuition Credits Hope Scholarship Lifetime Learning BVSource.com
Mortgage Interest Deduction IRC § 163(h)(3) Acquisition mortgage loan up to $1MM Home equity mortgage loan up to $100K “Qualified residence” Principalresidence 1 other residence BVSource.com
Tax Consequences of Marital and Community Property Property Transfers in Divorce Distinguishing Pre-Tax from After-Tax Assets in Divorce Quantifying After-tax Value of Property in Divorce BVSource.com
Property Transfers in Divorce Non-recognition of income or gain upon transfer Retention of transferor’s basis BVSource.com
Pre-tax or After-tax? Real Estate Retirement Plans Bank accounts Stock, stock options, mutual funds Life Insurance Tangible Personal Property BVSource.com
Quantifying After-tax Value Real Estate Stocks, stock options Defined contribution retirement plans Defined benefit retirement plans BVSource.com
Installment Payments Interest on Deferred Equitable Distribution Payouts BVSource.com
Food for Thought Tax Assets – Carryforwards Tax Refunds Forgiveness of Debt Heavily Depreciated Assets Indemnification Agreements BVSource.com
Thank You! Brian C. Vertz, Esq., MBA, AVA Pollock Begg Komar Glasser LLC Pittsburgh, PA BVSource.com Brian@BVSource.com BVSource.com
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