Have You Considered the Tax Consequences of Your Divorce Agreement?

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Most divorcing couples come to the table knowing that division of assets, time with children, and money are all areas central to reaching a settlement.  Others are aware that they also need to address questions pertaining to health insurance coverage and even life insurance.  Few, however, consider the tax implications of their agreements.

At the Centre for Mediation and Dispute Resolution, we suggest that all agreements need to include consideration of tax implications, lest you realize tomorrow that the agreements you reached do not provide you with the moneys you anticipated at the time of settlement.

Here is a sampling of areas with tax implications, which should be considered, where applicable, in your divorce settlement:

I.  Child-Related Taxes:

• Dependency exemptions have been suspended for tax years 2018 through 2025 by the Tax Cuts and Jobs Act of 2017.

• Child tax credit and childcare tax credit cannot be split or shared even if you have joint custody.  The parent with whom the child lives most nights is considered the custodial parent and eligible to claim the credit.  However, the claim may be released to the other parent if eligibility requirements are met. (These are income capped credits.)

• Head of household status may need to be negotiated in a shared custodial arrangement where there is only one child. For example, parents may alternate years of filing as head of household.

• Education-related credits and/or deductions are also income capped.

II.  Real Estate Sales

• It is necessary to calculate the capital gains taxes and, if an investment property, to consider gains or any applicable losses.
  
  
• In the sale of the marital home, consider, for high-end houses, the structuring of an agreement that includes the non-resident spouse’s tax exclusion.  Here, striking a bargain may well pay off for both spouses.

III.  Investment Gains and Losses

• In structuring your agreement, be sure that you and your spouse consider the impact of losses and gains in the calculation of moneys received by each party. 

• For inheritance funds: be sure that you use the correct tax basis in undertaking your calculation.

IV.  Retirement Funds

• Consider penalties and taxes for early withdrawals.

• Important to know: retirement funds can be transferred from 40lk(s) and 403b(s) from one spouse to the other and withdrawn without penalty prior to retirement age. (Taxes will still be owed.)

• Project the tax-deferred growth of funds prior to withdrawal and taxes owed in the future.

V.  Life Insurance Policies (w/Equity)

Be aware that ordinary income taxes will be incurred on the cash received from surrender of policies if the amount of the premiums paid is less than the amount of the cash surrender value.

VI. Term Life Insurance

Typically, payouts from term life insurance policies are not considered income.

VII. Transfer of Property

Transfers of assets in divorce generally constitute a tax-free transfer to the recipient.  Retirement funds can also be transferred from one spouse to the other without any tax implications provided that the funds stay in tax-deferred retirement accounts.

VIII.  Support

• Child support is received by the recipient as nontaxable income.  As such the paying spouse makes the payment in after-tax dollars.

• Beginning with 2019 Agreements, alimony received by the recipient is non-taxable income for Federal tax filings.  Dependent on the state, alimony may still be taxable income to the recipient.

It is important to note that the terms of your agreement can result in a taxable event unintended by the parties.  Therefore support payments need to be structured with full awareness of the tax pitfalls and implications under various situations.  Moreover, understanding that tax laws may change over time suggests that your agreement incorporates provisions for future review and modification of terms.  It is perhaps worth noting that the various provisions of the 2017 Tax Cuts & Jobs Act will “sunset” at the end of 2025.  What will happen in 2026 is anyone’s guess.

These examples constitute only a smattering of the many tax implications inherent in each couple’s divorce settlement.  In order to protect both spouses from unpleasant surprises, it is crucial for both parties to understand what they are receiving and what they are really giving up in fashioning their agreement.  Often parties can create better, more beneficial agreements, by “giving” to their spouse in areas that will not have a negative impact on their own settlement.  The problem-solving element of mediation presents an ideal forum for analyzing tax implications and weighing their “value” to each party… In the end, the parties’ agreement should focus on tax savings and advantages to be achieved by both parties sharing the common goal of optimizing the “goodness” of their agreement for the family.