Tax Implications of Special Circumstances - Divorce
An unfortunate fact of life is that divorce happens to hundreds of thousands of families each year. There are several items that need to be considered when this happens, such as medical insurance availability, alimony, child support, division of property, who will live in the home and the time, stress and money spent on attorney's fees to finalize the actual divorce. For the tested exam material, we'll focus on alimony, child support and property. Alimony
It's smart to arrange beforehand in the divorce or separation papers, whether alimony payments are going to deductible by the payer and taxable to the payee, or vice versa. The best outcome for both parties would be tax-deductible payments for the payer and tax-free income for the recipient. However, this is not an alternative, so both parties will have to compromise by setting amounts and tax consequences that balance both of their interests.
Requirements of "Qualified Alimony:"
- Payments must be made in cash,
- Payment is for the benefit of the payee ex-spouse (not treated as child support),
- Taxpayers cannot live together at time of payment,
- Taxpayers cannot file a joint tax return and
- Payments cannot continue after the death of the recipient (payee- ex-spouse).
Tax Treatment of "Qualified Alimony:"
Deductible by payer (sender of the funds)
Taxable to payee (recipient of the funds)
- To qualify, alimony payment must be in cash.
- If divorce decree specifies, payments can be made to third parties for other obligations of the payee, such as ex-spouse's rent, life insurance payments, taxes, mortgage, tuition, etc…
The following will NOT be treated as Alimony:
- Transfers of non-cash items, promissory notes, property, services or use of property will not qualify as alimony payments.
- Payments made to maintain property OWNED by the payer, but USED by the payee will not qualify as alimony payments. Examples include mortgage payments, real estate taxes and car payments for property owned by the payer but being used by the recipient ex-spouse.
*Even if the official divorce document states that such transfers or payments must be made on behalf of the ex-spouse, they will NOT qualify as alimony for deductibility purposes.
Under many divorce conditions, one spouse may obtain full or partial custody of the children, and be awarded child support payments in accordance with a divorce or separation instrument. Money received for child support is not included as income, and money paid for child support is not deductible.
- Child support payments are NON-DEDUCTIBLE to the payer.
- Child support received is NON-TAXABLE to the recipient.
Under Section 1041 of the IRS tax code, most property transfers between spouses are treated as tax-free exchanges (unless spouse is a nonresident alien). This rule also applies to property settlements between spouses incident to a divorce.
Spousal Property Transfer Rules:
- Property transferred due to divorce… No taxable gain, No deductible loss for either party.
- Property transferred retains the same adjusted cost basis as it had prior to the transfer (carry-over basis).
Qualified Domestic Relations Order (QDRO) – This document is issued by the domestic relations court to conform to IRS regulations in providing pension administrators and individual retirement account (IRA) custodians a guide as to how to pay benefits to a divorced spouse.
Treatment of Retirement Accounts
Retirement accounts such as 401(k) plans and IRA accounts can be split and transferred between spouses per the instruction in the QDRO without tax consequences to either party.
Treatment of Life Insurance
If a life insurance policy is transferred during a divorce settlement, the event is considered a non-taxable transfer of property incident to a divorce. Even if the policy contains "cash value," the transfer will have no income tax consequences. Death benefits will continue to retain their income tax free status.