Tax Consequences in Divorce

Tax consequences should always be considered as central to any financial decision in a divorce action. Yet, they are sometimes an afterthought of attorneys and parties who are aggressively seeking settlement of other key issues.

Parties often make choices which have considerable tax implications before they even see a divorce attorney to "formalize" the termination of their marriage. While the agreed resolution of the financial issues in the divorce case may appear fair on the surface, it may be far from fair once tax implications are factored in.

There are three main areas where tax consequences can be considerable: (i) in the valuation and division of property; (ii)in the allocation of child and/or spousal support; and (iii) in child deductions, credits, and exemptions.

Division of Assets and Liabilities

There are a couple of areas where tax consequences can be a key consideration in the division of assets and liabilities. The main types of potential tax liability associated with assets are: capital gains, recaptured depreciation, and realized income.

Capital gains taxes may apply if an asset appreciates in value over the period of time it is held by the couple during the marriage. The easiest example is a stock purchased for $50.00 per share during the marriage which is worth $100.00 per share at the time of the divorce. If the stock is sold, capital gains tax may apply to the $50.00 increase in the value in each share of the stock from the date it was purchased until the date of the divorce.

Generally, there will be no tax ramifications for a transfer by one spouse to the other of an interest in real property. However, if the property is sold, there will generally be a tax implication for any increase in the value of the house from the date it was purchased until the date it was sold.

If the real property was not the marital residence, but one used for business or rental purposes, there may be an additional problem of recaptured depreciation. If an asset is depreciated and then subsequently sold, the depreciation is deemed recaptured for income tax purposes and the result can be a substantial tax liability.
If a party accepts a majority of assets held in retirement accounts, the party needs to realize that those assets will be subject to income tax once liquidated and may be subject to penalties for early withdrawal depending on when they are liquidated.

Spousal Support & Child Support Provisions

Tax consequences also result from the determination of whether support payments by one spouse to the other will be in the nature of child support or spousal support. The general rule is that spousal support payments are taxable as income to the recipient spouse and are deductible as an expense for the paying spouse. However, child support payments have no income tax implications either way.

Care must be taken in structuring spousal support payments which are intended to be tax deductible to the spouse paying the support. The spousal support recapture rule provides that annual spousal support payments decreasing by more than $15,000.00 or ending during the first three years after the marriage ends may result in tax liabilities that were deducted in prior years. Determining whether support recapture will apply entails the use of two fairly complicated formulas which are beyond the scope of this book. Suffice it to say, however, that the issue of support recapture should be raised with the divorce attorney and considered in the structuring of any support arrangement.

One final note regarding support recapture. Even experienced divorce attorneys may be taken by surprise by the following issue. The determination of whether recapture occurs during the first three years is based on the calendar year, not 12 month periods. Thus, a red flag should be raised whenever spousal support payments are scheduled to commence in the latter part of a calendar year.

Child Deductions, Credits, and Exemptions

Through the allocation of parental rights provisions of the divorce decree, the Court is charged with allocating dependency exemptions for the minor children between the parties. Often the dependency exemptions are alternated, but the Ohio Revised Code provides that, should the issue proceed on a contested basis, the allocation of these exemptions shall be made so as to maximize the tax benefit for the parties.

Parties should be careful to make sure that the income tax benefits of providing health insurance and day care coverage for the minor children are taken into consideration when credit for those expenses are given in the calculation of child support. Most often overlooked, however, are the determination of head of household status as well as earned income tax credits.

Given the myriad of tax questions and issues which occur before, during, and after a divorce proceeding is initiated, one cannot address them all here. However, a great source of information is Divorce Source's Federal Income Tax FAQs Page.