Divorce signals more than just the end of a marriage — it is also the end of a financial partnership. Like all things that involve finances, the Internal Revenue Service (IRS) will likely get involved. Thankfully, the IRS does not tax the majority of the financial split that happens during divorce, but there are some things to be aware of that could trigger taxes. You can help get a better understanding of the role of taxes in divorce by asking these three questions.
#1: Do I need to worry about taxes if I take the family home?
If you were buying a home, you would need to pay taxes. If you agree to give up other assets to keep the family home, would you need to pay those same taxes? Thankfully, when the reason for the transfer is divorce the answer is generally no. But you will likely need to pay any capital gains tax if you choose to sell your property in the future. Depending on how much the home has increased in value, this could translate to a big tax bill if the plan is to get the home and sell it later.
#2: What about retirement assets?
This is where things can get very difficult. It is important to take retirement assets into account during divorce. The money put aside to fund retirement accumulates over the years and is very difficult to make up in our thirties, forties, fifties, and beyond. As a result, it is generally wise to get a portion of these assets during divorce. However, a failure to follow the rules (and there are many) when splitting retirement assets can result in a large tax bill.
Each asset can have different rules. Pensions and 401(k)s, for example, often need special paperwork, known as a qualified domestic relations order (QDRO), to transfer the asset without penalty. Explaining the division within the divorce settlement agreement is not enough.
#3: What about spousal or child support?
Does the IRS expect income taxes or allow tax deductions for these payments? Child support is pretty clear. The IRS does not consider child support payments as a tax deduction or as taxable income. Alimony or spousal support is more complicated. In the past, divorcing couples could use tax benefits to help justify a larger spousal support, or alimony, payment because the paying spouse could write the payment off as a tax deduction. This is no longer the case. A few years ago the Tax Cuts and Jobs Act (TCJA) led to major tax reform. Part of these changes included the removal of this tax benefit. As a result, divorces finalized prior to 2018 may still get this tax benefit, but those finalized or modified after December 31, 2018 do not.
Failure to meet the IRS’ expectations can result in a tax audit, which is likely not something you want to deal with after going through a divorce. You can reduce this risk by discussing these three questions during divorce negotiations.
It is important to note that these three questions are a starting point. Each divorce is unique and will require tailored discussions to better ensure all potential issues are resolved before the divorce is finalized.