It’s tax season — that time of year when millions of Americans struggle through the endless paperwork, stress and strife of preparing tax returns. For those who are contemplating, in the midst of, or just out of a divorce in Arizona, the difficulties of tax season pose an even greater challenge. The stakes are high and the penalties for mistakes are severe, making it critical that you avoid the traps and missteps that plague the world of tax and divorce.
With that in mind, and before you file your return, here are Four Things You Must Know About Divorce and Taxes:
1. The Key Difference Between Alimony and Child Support
Alimony (support paid from one spouse to another for the benefit of the receiving spouse), is different from child support (support paid from one spouse to another for the benefit of the child) in several ways, one of which is critical in tax season: alimony is tax deductible by the payer and child support is not.
Similarly, alimony is taxable income to the receiving spouse, while child support is not. When negotiating a divorce settlement, people sometimes (mistakenly) believe that alimony and child support dollars are equivalent, but their disparate tax treatment means they could not be more different.
2. The Tax Impact of Dividing Property
Thanks to §1041 of the Internal Revenue Code, the division of property in a divorce is not a taxable event. There is, however, a potentially huge tax impact hidden within: tax basis. Tax basis is, simply put, the price used to determine the capital gains tax when property is sold (usually the purchase price). While some property (such as cash) carries no capital gain when sold and other property (such as a residence owned by the taxpayer) has an exemption from capital gain up to a given dollar amount, many forms of investment will be hit with a capital gains tax when sold.
So, in a divorce settlement $250,000 worth of Apple stock is not worth the same as a $250,000 marital residence because the stock will be subject to capital gains tax when sold while the residence will not.
3. Understanding Your Filing Status
There are different filing statuses available (depending on certain factors) for those going through divorce: single, married, or head of household. Different statuses (as well as the decision whether to file jointly or separately with a spouse) may yield significantly different tax liabilities.
It is difficult to predict the precise impact of the different filing statuses and options without actually preparing multiple versions of a single year tax return to see which is most advantageous. While preparing multiple versions is an onerous task, it is also an investment of time which may yield hundreds or even thousands of dollars in tax savings.
4. Which of Your Divorce Attorney’s Fees Are Tax Deductible
Unfortunately, most of the fees paid to a divorce attorney are not tax deductible. There is, though, one loophole: §212 of the Internal Revenue Code allows that fees paid to a divorce attorney in the production or collection of gross income are tax deductible. While probably not all, or even most, of the fees you’ve paid will qualify under for this deduction, a knowledgeable divorce attorney in Arizona will help you make sure you receive credit for every tax-deductible dollar you have paid.
In Arizona, upon the dissolution of a marriage, all marital property will have to be divided amongst the spouses. The dividing of most assets will not trigger a tax event; the IRS has created a rule allowing for any spouse-to-spouse transfer that takes place incident to divorce to be tax-free. Thus, a lump sum payout from a checking or savings account can be transferred with no tax implications. Vehicles, jewelry, and other personal property can also be transferred tax-free.
Some marital assets, however, automatically trigger tax consequences that can be costly if not handled property. For instance, retirement accounts are specifically designed so that early withdrawals result in a major tax hit. So regardless of the IRS rule about tax-free transfers incident to divorce, if a divorcing spouse withdraws funds from a retirement account to give to his former spouse, he will inevitably face tax consequences.
Retirement accounts need to be handled delicately. In order to avoid tax penalties when transferring an IRA, the spouses must follow the procedure to transfer or rollover the funds to another retirement plan in order to avoid a tax issue. Other retirement accounts are more complicated and require additional steps in order to be tax-free. For qualified employer accounts such as a 401K or a pension, the spouses must obtain a Qualified Domestic Relations Order to ensure the transfer is tax-free.
The transfer of stock options can also be tricky; the IRS treats statutory stock options different from non-statutory stock options. The latter option will result in a capital gain when exercised, while the former will not. Sometimes parties will simply agree to a monetary value that the options will be worth once exercisable, and the non-owning spouse will receive that amount as a lump sum from the other spouse. Another option is to include a provision in the separation agreement or court order expressing that the employee-spouse who owns the options will hold them on behalf of the other spouse until they are exercisable.
Selling the marital residence incident to divorce can also create tax issues. Depending on the circumstances, the parties may be hit with capital gains taxes.
The bottom line is that spouses should be aware that splitting assets can be complicated and costly if not done correctly. In order to make sure neither spouse takes a tax hit, both spouses should consider the tax consequences of any transfer and consult a professional if there are any concerns.
Unlike alimony payments in Arizona, child support payments are never taxable nor deductible. There are, however, several other tax implications that take effect upon separation that deal with children. Arguably the most important child related tax consideration is the dependency exemption.
The exemption, similar to a tax deduction in operation, reduces a person’s taxable income by a set amount. Parents can either agree who is entitled to take this exemption, or the IRS rules will allow the custodial parent to take the exemption. The custodial parent is the parent who has custody for a greater portion of the calendar year. Whichever parent claims the dependency exemption is also entitled to claim the child tax credit. The tax credit allows a parent to reduce federal income tax by as much as $1,000 per child. The amount of the credit is dependent on the applicable modified adjusted gross income.
For Arizona married couples filing separate returns, the amount of the credit begins to decrease (or phase out) if your income is $55,000, and for divorced parents the threshold is $75,000. The only parent who may claim this tax credit is the parent who also claims the dependency exemption; the two cannot be split. Not all child-related tax credits are tied to the dependency exemption. For instance, the child and dependent care credit, which gives a parent credit for child for a portion of childcare expenses, is not tied to the dependency exemption.
There is also a medical expense deduction applicable to parents who contribute more than 7.5% of their income to their child’s medical expenses, which is not tied to the dependency exemption. A parent may claim either of these, if certain requirements are met, even if they do not claim the child as a dependent.
Alimony is money paid by one spouse to the other spouse, after separation, in order to provide the receiving spouse with support. Alimony is also sometimes referred to as spousal support, financial support, subsistence, upkeep or maintenance. Regardless of which term is used in your court order or separation agreement, the same tax implications will apply.
Alimony is taxable to the spouse who receives the payments. He or she will have to report the alimony payments as earned income, and will be taxed on this money just as if it were a salary or wages. Alternatively, the paying spouse can claim a deduction on alimony payments, so long as certain requirements mandated by the IRS are met.
Should the spouses determine that it is preferable in their situation to avoid the taxable/deductible nature of alimony payments, they may do so by including a provision that states exactly that. For instance, the spouses can simply assert in a separation agreement that the alimony payments are neither taxable nor deductible, and by doing so they are able to avoid the tax implications that would otherwise apply.
There are further rules set forth by the IRS regarding alimony payments in Arizona. For instance if alimony is front-loaded for the first year or two, the paying spouse may be penalized under the alimony recapture rule. Additionally, the IRS has imposed special rules regarding how to treat alimony payments if they are being attributed to pay the mortgage on the marital residence, and there are other considerations regarding alimony trusts.
Our team of family law attorneys and divorce attorneys look forward to helping you when you need it most. With over two decades of aggressive divorce, child custody, child support, and divorce mediation representation we will not allow you to be taken advantage of. We believe in making a difference in the lives of our clients and their children.
Located in Mesa Arizona, on Val Vista and Southern Avenue. Our Family Law Attorneys and Divorce Lawyers in Mesa AZ have been helping our clients achieve the legal results they are searching for. Our Mesa Law Firm offers Divorce Mediation, Uncontested Divorce, Contested Divorce, Legal Separation, Female Divorce Lawyers, Annulment, Child Support Issues, Child Custody, Military Divorce, Parenting Plans, Prenuptial Agreements, Postnuptial Agreements, Grandparents Rights, Paternity, Order of Protection, Name Change and all Family Law legal issues.
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Jensen Family Law in Mesa is located on 3740 E Southern Ave Suite 210, 85206 Mesa, Arizona. From Phoenix Sky Harbor International Airport (PHX), Take S 41st St to E Sky Harbor Blvd, then head west on E Sky Harbor Blvd and Use the left lane to take the exit toward S 41st St. Then Turn right onto S 41st St. After that, Continue straight to stay on S 41st St, then Take AZ-202 Loop E, AZ-101 Loop S and US-60 E to S Val Vista Dr in Mesa. Take exit 184 from US-60 E after that Merge onto E Sky Harbor Blvd, then Use the left 2 lanes to merge onto AZ-202 Loop E toward Tempe/Mesa and Use the right 3 lanes to take exit 9 to merge onto AZ-101 Loop S. After that, Use the right 2 lanes to take exit 55A-B to merge onto US-60 E toward Globe, then Take exit 184 for Val Vista Dr. Then Continue on S Val Vista Dr to your destination and Turn left onto S Val Vista Dr. Turn right onto E Southern Ave, then turn left and Destination will be on the right.
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