Going through a divorce is a major life transition, and it comes with a series of financial and legal decisions that can impact your future. One of the most complex aspects to navigate is how to handle your taxes while your divorce is still pending. Filing taxes during divorce requires a clear understanding of IRS rules, and communication between spouses (when possible). It also requires careful consideration of support payments, dependents, and filing status. This guide will help you understand what to expect and how to prepare for filing taxes during divorce.
Understanding Tax Implications While Your Divorce Is Pending
If your divorce is still in progress by the end of the calendar year, the IRS will likely consider you legally married for tax purposes. Your marital status as of December 31 determines your filing options for that year. That means even if you separated months ago and are living apart, you may still need to file as a married person unless you meet specific qualifications.
The IRS does not recognize informal separations for tax filing purposes. Only legal separations ordered by a court or finalized divorce decrees change your marital status in the eyes of the IRS. If you are still married on December 31, your filing options typically include Married Filing Jointly or Married Filing Separately.
If you and your spouse are living apart and no longer financially cooperating, the situation can get complicated. Even though you may be emotionally and physically separated, unless the court has issued a legal separation decree or finalized your divorce, your filing choices remain limited.
Choosing the Right Filing Status During Divorce
The first step in filing taxes during a divorce is determining your correct filing status. This first step will be one of the most important tax decisions you’ll make during a divorce. It affects your tax bracket, your standard deduction, and your eligibility for many tax credits and deductions.
When Joint Filing Makes Sense
Your marital status as of December 31st of the tax year will determine whether you file as single, married filing jointly, or married filing separately. If your divorce is not yet finalized by that date, you may still have the option to file jointly with your spouse.
Married Filing Jointly often results in the lowest overall tax liability for couples. However, during divorce proceedings, filing jointly may not be a viable or safe option. If there’s a lack of trust between spouses, or concerns about one spouse misreporting income or deductions, it may be wiser to file separately to avoid being held liable for the other’s tax mistakes. Consider consulting with a tax professional to understand the most advantageous filing status for your situation.
Risks of Filing Separately
Married Filing Separately generally results in higher taxes, as many credits and deductions are reduced or disallowed. For example, the Earned Income Tax Credit is not available, and the Child and Dependent Care Credit is limited. However, filing separately may be necessary to protect your own finances.
Qualifying for Head of Household
In some cases, one spouse may qualify to file as Head of Household even though the divorce is not yet finalized. To do so, the individual must have paid more than half the cost of maintaining a home and have a qualifying child or dependent living with them for more than half the year. This filing status offers a larger standard deduction and more favorable tax brackets than filing as single or married filing separately.
Imagine a scenario where a couple separated in July, and the mother continued to live with their two children. She paid the mortgage, utilities, groceries, and all other household costs. Even though she is not legally divorced by December 31, she may qualify as Head of Household if she meets all the IRS criteria.
Selling Assets During Divorce: Tax Consequences and Reporting Rules
Selling jointly owned assets as part of a divorce can trigger tax consequences, depending on the type of asset, its cost basis, and how the proceeds are split. Understanding how these transactions are treated by the IRS can help both parties avoid unexpected tax bills.
Capital Gains on the Sale of Real Estate
When a couple sells their primary residence during divorce, they may be eligible to exclude up to $500,000 in capital gains from their income, provided they meet certain criteria. To qualify for the full exclusion, both spouses must have owned the home and lived in it as their primary residence for at least two of the last five years. If only one spouse meets the residency test, the exclusion may be reduced to $250,000.
For example, if a divorcing couple sells their home for $850,000 and their adjusted basis in the home is $400,000, their gain is $450,000. As long as they meet the IRS ownership and use tests and file jointly, they may be able to exclude the full gain. However, if they file separately and only one spouse qualifies, the taxable gain could be much higher.
It’s also important to consider the timing of the sale. If the home is sold after the divorce is finalized and the title has been transferred to one spouse, that spouse alone may be responsible for any capital gains—even if both parties agreed to split the proceeds. Consulting a tax professional can help you navigate the complexities of property division without unexpected tax consequences.
Selling Investments and Shared Property
Beyond real estate, couples often sell stocks, mutual funds, or other investments during divorce to divide assets or generate liquidity. These sales may trigger capital gains or losses. However, it’ll depend on the difference between the asset’s sale price and its original purchase price (the basis).
If the couple held the asset jointly, the gain or loss is generally split equally. However, each spouse may be taxed individually based on how the asset was titled and what was agreed upon in the divorce settlement. Selling long-term holdings (owned for more than one year) typically results in more favorable tax treatment than short-term gains, which are taxed at ordinary income rates.
Suppose a couple sells $100,000 in jointly owned stock with a cost basis of $60,000. They realize a $40,000 capital gain, which they plan to divide evenly. Each spouse would report a $20,000 gain on their individual tax return if filing separately.
Property Transfers Without Immediate Tax
Not all asset divisions during divorce result in immediate taxation. Under IRS rules, transfers of property between spouses (or former spouses) are generally non-taxable. This means that if you receive an asset as part of your divorce decree—such as a car, investment account, or even a second home—you don’t recognize gain or loss at the time of transfer.
However, you also inherit the original cost basis and holding period of the asset. This can create future tax issues if you sell the asset later and realize a large gain. For example, say you receive stock your spouse bought for $10,000. If it’s now worth $50,000, you won’t owe taxes at the time of the transfer. But if you later sell it for $55,000, you’ll have to report a $45,000 capital gain. This rule underscores the importance of understanding the after-tax value of assets you receive in a divorce.
Dividing Retirement Assets Strategically
Selling or withdrawing from retirement accounts during divorce should be approached with extreme caution. Doing so without proper legal structure can trigger income taxes and early withdrawal penalties.
To split a 401(k), pension, or other employer-sponsored retirement plan, you need a Qualified Domestic Relations Order (QDRO). This court order allows a portion of the account to be transferred to a former spouse without triggering taxes or penalties. The receiving spouse becomes responsible for taxes only when they withdraw the funds.
IRAs, on the other hand, don’t require a QDRO, but the transfer must be specified in the divorce decree. Once properly transferred, the receiving spouse owns the funds and will pay taxes only when distributions begin. Avoid the mistake of simply cashing out retirement assets during divorce. Unless you meet an exception, doing so before age 59½ usually results in a 10% early withdrawal penalty on top of regular income tax.
Reporting Sales and Transfers on Your Tax Return
If you sell an asset during divorce, you’re responsible for reporting the transaction on your individual tax return. This includes reporting any capital gains or losses on Schedule D. Be sure to provide documentation such as purchase price, date of acquisition, and sale proceeds.
If assets were transferred to you by your ex-spouse, you won’t report anything at the time of transfer, but you will use their original basis when you eventually sell. Keep records of the original cost, holding period, and any depreciation (for property like rental real estate). These details will affect your future tax liability. When preparing your return, make sure to coordinate with your divorce agreement and review any IRS forms or attachments required. These can include Form 1099-S for real estate transactions or Form 8606 for non-deductible IRA contributions.
Who Claims the Children on the Tax Return?
If you file jointly with your soon-to-be ex-spouse, figuring out who claims the kids will be easy. However, if you file separately, you’ll want to discuss who should claim your child(ren).
IRS Rules for Custodial Parents
Generally, the custodial parent—the one with whom the child lived for the greater number of nights during the year—is allowed to claim the child as a dependent. If custody is evenly split, the IRS uses tie-breaker rules. Usually the parent with the higher adjusted gross income (AGI) gets the right to claim the child.
Using Form 8332 to Transfer Exemptions
However, parents can agree to alternate years or assign the right to claim the child to the non-custodial parent using IRS Form 8332. This form allows the custodial parent to release their claim to the exemption for a particular year. For example, if the parents agree that the father will claim their child in odd-numbered years and the mother in even-numbered years, the custodial parent must sign Form 8332 each applicable year.
Tax Benefits of Claiming a Child
Claiming a child provides access to several tax benefits, including the Child Tax Credit. This credit can reduce your tax bill by up to $2,000 per child. In some cases, part of this credit is refundable. Other potential benefits include the Earned Income Tax Credit and the Child and Dependent Care Credit, which can help offset the cost of childcare.
Be Prepared for Tax Implications of Alimony and Child Support
In your divorce, the court may order you or your spouse to pay alimony. Alimony is financial support for a spouse during separation or after divorce. In addition, the court may also order one of you to pay the other child support. The IRS allows alimony payments to be deducted from taxes if your divorce was finalized by December 31, 2018. On the other hand, these alimony recipients need to report that money as income and pay taxes on it. If your divorce was finalized after December 31, 2018, then you cannot deduct alimony payments from your taxes. However, alimony recipients still must report the payments received as income.
Child support payments are not tax-deductible. Payments received do not need to be reported as income. Even if the payer is providing significant financial support, these payments don’t affect either party’s tax return directly. However, failing to pay court-ordered child support can result in garnished tax refunds.
Splitting Income and Deductions Mid-Divorce
While a divorce is pending, splitting income and deductions fairly between spouses can be a major point of confusion. This is especially true for couples who file Married Filing Separately but still share financial obligations or assets. Income from wages, interest, dividends, rental property, and businesses must be reported accurately. If you and your spouse own a joint business or rental property, you will need to divide the income and expenses appropriately. The IRS allows some flexibility, but documentation is critical.
Shared deductions such as mortgage interest, property taxes, charitable contributions, and medical expenses also need to be split. Typically, each spouse may deduct the portion they actually paid. For example, if you paid the entire mortgage interest for the year, you may claim the full deduction even if the home is jointly owned. But if both spouses contributed, each must only claim their share. This division can become even more complicated when a couple has a child in college. If both parents contributed to tuition or took out loans, only one can claim the education credit. Coordinating this with your spouse’s tax filing is essential to avoid duplicate claims and potential audits.
Managing Tax Documents and Financial Transparency
During divorce, transparency is key to avoiding tax trouble. Both spouses should retain access to all relevant tax documents including W-2s, 1099s, bank statements, and mortgage interest forms. If one spouse is less forthcoming, this can become a legal issue during the divorce process. It is not uncommon for one spouse to file a return without informing the other or to manipulate income or deductions in their favor. This is why some individuals choose to file separately during divorce. Even though it costs more, it reduces the risk of being liable for the other person’s tax issues. If you are unsure how income or assets are being reported, request a tax transcript from the IRS.
When to Involve a Tax Professional or Divorce Financial Specialist
Divorce is not just a legal process—it’s a financial one. If your tax situation is at all complicated, involving a tax professional can save you significant stress and money. This is especially true if you own a business, hold substantial investments, or have international income. A Certified Public Accountant (CPA) or Enrolled Agent can provide advice on your tax filing options and help you estimate the implications of various support arrangements. A Certified Divorce Financial Analyst (CDFA) specializes in forecasting how financial decisions made during divorce will affect long-term wealth and taxes.
Tax Help for Those Going Through Divorce
Filing taxes during a divorce requires careful attention to detail and a clear understanding of your financial situation. By determining your filing status, gathering the necessary documents, addressing alimony and child support, considering property division implications, determining dependency exemptions, and exploring tax credits and deductions, you can navigate this process successfully. Remember that seeking professional advice is invaluable to ensure you meet your tax obligations accurately. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers.
If You Need Tax Help, Contact Us Today for a Free Consultation