In the midst of a divorce, most taxpayers will be looking for any opportunity to reduce their tax burden and defray the costs associated with the proceedings. An experienced attorney will be on the lookout as well, helping to identify opportunities for savings on expenses incurred before, during and even after the divorce is final. With a little forethought and a solid understanding of the rules and regulations, attorneys can ensure that their clients fully understand the potential savings that may be available to them and integrate any deductions or exemptions into a thoughtful, forward-looking tax plan.
Deducting Expenses Related to the Divorce
In general, fees and expenses related to a divorce are considered to be non-deductible personal expenses. However, the IRS does allow the deduction of expenses related to seeking alimony payments, maintaining or managing income properties, and obtaining tax advice related to the divorce settlement.
Not all expenses related to alimony or property are deductible, however. Expenses associated with the payment of alimony and the cost of property transfers do not qualify, although the fees paid for tax advice related to the transfer may be deductible. Even when certain expenses are eligible for a deduction, the amount of that deduction may be subject to other limitations — they may be lost if the taxpayer uses the standard deduction or is subject to the alternative minimum tax.
Family law attorneys can aid their clients by maintaining careful records and itemizing billings related to tax advice or the production and collection of income. Doing so could potentially help save the client thousands of dollars.
Deducting Payments Made After Divorce
As a general rule, child support payments are neither deductible for the paying spouse nor taxable income for the parent receiving the support. Alimony, in contrast, is considered a taxable event and the amounts paid are deductible for the paying spouse and taxable for the recipient.
In order to qualify as alimony, strict requirements must be met:
- Payments must be made pursuant to a divorce, maintenance decree or written separation agreement that does not designate the payment as anything other than alimony (such as child support, for example)
- Payments must be made in cash
- Liability for support must end with the payer's death
- The spouses may not live in the same household
If all of these requirements are met, the payments qualify as alimony and can be deducted from the tax bill of the spouse making the payments. Because alimony is an "above-the-line" deduction, the paying spouse does not need to itemize the payments in order to benefit.
Life insurance may also be used to ensure the payment of alimony or child support. In cases where an individual is the insured party in a valid life insurance policy, but their former spouse is both the owner and beneficiary of the policy, the payment of premiums by the insured spouse may be deductible as alimony. However, this is not the case if the insured spouse retains policy ownership, even if the policy names the former spouse as beneficiary.
From a tax planning perspective, alimony is not subject to tax withholding (which means a recipient spouse may need to adjust their tax payments during the year) and is taxable in the year received. Due to the tax treatment of alimony, divorcing spouses may be tempted to characterize other payments, such as child support or property transfers, as alimony. As a result, the IRS has implemented special rules which may require the recapture of alimony as taxable income for the recipient in some cases, such as if there is a significantly large alimony payment shortly after a divorce is finalized.
Deducting Mortgage Interest Payments
Homeowners are permitted to deduct mortgage interest payments on loans of up to $1 million in value, provided the mortgage is secured by a "qualified home," that is, a primary or secondary residence that has sleeping, cooking and toilet facilities. They may also deduct the interest paid on home equity loans of up to $100,000.
In the past, these limits were applied on a per-residence basis, meaning that former spouses who owned property together needed to figure out how to split this deduction up among themselves. Since August 2016, however, the IRS has allowed these amounts to be applied on a per-taxpayer basis, meaning that each spouse is entitled to the full $1.1 million deductible interest limitation.
Claiming the Dependency Exemption
In addition to a personal exemption, taxpayers are permitted to claim one exemption for each person claimed as a dependent. This dependency exemption is similar to a tax deduction, as it reduces taxable income, potentially resulting in the payment of less income tax.
In order to qualify for the dependency exemption, the dependent being claimed must generally meet the following requirements. They must:
- Be a qualifying child or relative
- Not be claimed as a dependent on anyone else's return
- Be a U.S. citizen, resident alien or U.S. national
- Be single or, if married, have not filed a joint return with a spouse for the tax year
- Be under the age of 19, under the age of 24 if a current student, or have gross income less than the exemption amount for the tax year
- Receive more than half of their support (such as food, shelter, clothing, medical and dental care, or education) from one or both spouses
While only one taxpayer may claim a child as a dependent in a given tax year, a divorcing couple can choose to structure how the exemption is claimed in order to maximize the tax benefit.
For example, the IRS presumes that the custodial parent — usually the parent who has physical custody of the child for most of the year — is entitled to the exemption for children. There are, however, times when it can make sense for the non-custodial spouse to claim the exemption. If the custodial spouse cannot benefit from the exemption (for example, in the event that their income is too high for them to benefit), they may choose to give it to the non-custodial spouse. Spouses may also be able to structure the use of dependency exemptions as part of a creative settlement solution by alternating who claims the exemption from year to year or, when there is more than one child, splitting the dependency of the children between the spouses.
Work Collaboratively to Develop a Long-Term Plan
By walking through the deductions and exemptions relevant to a client's specific situation, attorneys can put their clients' minds at ease and leave them feeling confident that they aren't missing out on any potential savings. But to truly craft a plan that addresses long-term needs, an attorney will need to work collaboratively to ensure that a client's tax and estate plans are implemented properly and efficiently. Bringing in an experienced wealth manager can provide a holistic perspective that fully considers all aspects of a client's circumstances, building a complete financial picture that will serve them well not just this tax year, but long into the future.