Divorce is the process of dissolving (ending) a marriage before the death of either spouse. The process may sound easy by definition, but as many people know, it can be a very difficult process, emotionally and financially. One important problem that can occur in a divorce is the tax consequence.

There are many regulations enacted by the Internal Revenue Service (IRS) in regards to the tax consequences of a divorce and various sections of the Internal Revenue Code address or apply to them.

Common Issues

The following explanations contain a general summary of the more common issues that are likely to occur with respect to the tax consequences of a divorce. It may be advisable to call a tax advisor before the divorce is final. An advisor is especially important if the assets of the marriage include items such as a business, home(s), pension benefits, and other potential sources of complication. Thus, you should discover all of the tax implications early and plan accordingly.

Dependency Exemptions

The exemption for dependent children usually is awarded to the spouse that has physical custody of the children (the custodial spouse). However, the custodial spouse can choose to waive the right to the dependent children exemption, thus permitting the non-custodial spouse to claim it. Yet, it is most logical to award the exemption to the spouse who can gain the greatest tax benefit from it so that they will have more money to spend for child support or other such payments. However, this strategy may not always be used to its best advantage.

The exemption waiver may be made on an “annual” or “for all future years” basis. However, if performed on an “annual” basis, the custodial parent can deny the waiver to the non-custodial parent if, for example, support payments are late or for other important reasons.

When thinking about waiving the dependency exemption, one should also consider how higher education tax credits may affect your taxes, as these education credits are only available to the claiming parent.

Filing Status

The filing status used for income tax purposes for a divorcing couple is determined on the last day of a particular tax year. A person is considered still married by the IRS—even if separated—unless the final decree of divorce is confirmed by the last day of the tax year (December 31).

Unless the IRS sees official documentation stating otherwise, the federal and state governments consider the previous year’s tax return when deciding on marital status. If the final decree of divorce has not been completed by December 31 of the tax year in question, then the spouses must file as “married joint” or “married filing separately.” Therefore, even if you must file a tax return as a married couple, you still have two options.

Option #1:

If you file as “married joint,” in many cases it will mean lower taxes than when filing as “married filing separately.” However, when filing this way the IRS can legally hold either spouse financially responsible for all of the tax liabilities reported on the joint tax return. Also, when filing as “married joint,” the divorcing couple most likely will need to contact each other concerning the preparation of the joint return, which, for some, may not be a pleasant situation.

Option #2

If two people are legally divorced and living separately before December 31 of the tax year, then each spouse can complete a separate income tax return with the filing status of “single” or “head of household.” The spouse that is able to prove payment of over one-half of the costs and expenses of the household in which qualifying children live, along with meeting other requirements, may qualify under the more favorable “head-of-household” status.

Sale of Home

Taxes can be averted for up to $500,000 of gain if a married couple sells their personal residence in connection with a divorce or legal separation; that is, if the home was their principal residence for at least two years out of the previous five years.

If the home is not sold in connection with a divorce or legal separation but, instead, is sold later, then a gain can be avoided if the following is true: (1) the divorced couple has joint home ownership, and (2) only one spouse continues to live in the home.

Transfers of Business Interests

Transfers of business interests may have tax consequences for divorcing spouses. Business interests, such as partnerships and S corporations (S-corps), usually have carryover taxes that may draw special attention during a divorce or separation. Partnerships, especially, may cause complex and difficult tax issues, such as financial gains on contributed properties and various debt allocations. Careful tax planning is necessary to avoid adverse tax consequences in these situations.

Additional Resources

-- Divorce360: http://www.divorce360.com/articles/210/divorce-101-about-taxes.aspx

-- DivorceSource: http://www.divorcesource.com/research/edj/cases/tax.shtml

-- National Public Accountant (BNET): http://findarticles.com/p/articles/mi_m4325/is_n12_v37/ai_n25021583