Tax season is stressful for virtually everyone, but divorced parents face additional burdens. Those who have undergone a recent divorce have many emotional, financial and logistical issues to contend with already without adding on the nightmare of dealing with the tax issues surrounding children or dependents. Although much of the anguish from divorce is inescapable, some of the financial pain involved in this process can be alleviated through tax credits and deductions available for those who are eligible to file as head of household.
Dependent Relief from the IRS
The IRS passed a set of rules that came into play during the 2005 tax season that continue to apply. The rules changed the way divorced parents with dependents can file. These changes included:
- The traditional rules pertaining to divorce mandate that the custodial parent with whom a dependent child lives for more than half of the year will get the dependency exemption for that child on his or her tax return. If neither parent has custody of the child for more than half the year, then neither parent can claim the exemption. The rule does allow for time away due to vacations, summer camps, short visits with relatives, and so forth, but it does not allow for extended stays with other relatives or guardians who end up providing more than half of the child's support for the year.
- The main stipulation of the law resides in the support test, which determines who actually provided for the dependent child's support for more than half the year. A key point to remember here is that when one ex-spouse remarries, the joint income that he or she shares with the new spouse will count in the support test calculation. Of course, all of these conditions are subject to proper legal proceedings and court orders. If proper legal procedures are not followed, IRS regulations become irrelevant and many legitimate tax deductions and credits will be lost.
- Another key condition that must be met is that ex-spouses cannot have lived together in any capacity during the last six months of the year for which they are filing tax returns. If they divorced with less than six months before the end of the year, then they cannot have cohabited during the remainder of the full year.
Keeping Friendly - When Exemptions Can Be Shared
In many divorces, the spouse who is eligible to claim a dependent may not necessarily benefit from doing so. For example, the custodial spouse may not have sufficient income to benefit from the dependency deduction(s) and/or credit(s). In these cases, the custodial parent can sign Form 8332 with the IRS and waive the right to the exemption, allowing the other parent to claim the child on his or her tax return.
This waiver can be an important bargaining chip for many lower-income spouses who cannot gain anything from claiming a dependent child on their taxes. Release of this privilege to the non-custodial spouse can be traded for other divorce or custodial-related privileges that may be substantially more beneficial to the giver.
Who Benefits More?
Of course, from a tax perspective, the spouse with the highest adjusted gross income (AGI) will benefit the most from the dependency exemption. Taxpayers with high incomes may need to negotiate this issue with their ex-spouses, as a parent who makes $80,000 a year will obviously reap a substantially higher benefit from claiming a child than another parent making $28,000 a year. If there are multiple children or dependents involved in a case like this, then the income tax preparers for both spouses may need to experiment a bit with possible dependent scenarios in order to determine which arrangement will provide the maximum benefit for all concerned. In cases where the divorced couple have joint custody of a child and the child has lived with each parent for half of the year, the parent with the highest AGI will receive the dependency exemption by default.
Generally, the parent that can claim the dependency exemptions will also receive the corresponding tax credits, such as the child and dependent care tax credit and earned income credit for those with dependents. In most cases, only a divorce decree can specify otherwise. Of course, the tax credits for dependents can be much more valuable than the exemptions claimed; credits are prorated dollar for dollar against actual taxes due for taxpayers, whereas deductions simply reduce the amount of taxable income.
Regardless of who gets to claim the exemption or the credits, any parent that pays his or her child's medical bills can deduct them on Schedule A of his or her tax return, as long as he or she is eligible to itemize deductions. On a side note, an above-the-line deduction can be taken for this if the taxpayer is eligible for a health savings account.
One other overriding factor to consider is that no parent can claim a child if the parent is subject to the alternative minimum tax (AMT). While this issue is fortunately not a commonality at this point, it should be seriously considered by those who are affected by it.
The Bottom Line
Exemptions and credits can be vital bargaining chips for lower-income spouses who will not benefit from them, but desire other conditions from the divorce that may not be achievable. In many cases, only one spouse will benefit from claiming a child, regardless of all other factors. This spouse may be willing to make other concessions in order to realize this tax advantage.