Tax Tips and Traps

By Diana Shepherd on January 31, 2013

Here are two topics you’d probably rather not think about: divorce and taxes. If you’re separated or newly divorced, however, it could be worth your while to get some good financial advice about both.

Spousal Support

Also known in some areas as “alimony” or “maintenance”, spousal support is typically treated as taxable income to the person receiving it and tax-deductible for the person paying it. Before deciding whether a specific amount is going to work, you need to know what the actual out-of-pocket cost is if you’re the payor or the net amount that you’ll receive if you’re the payee. For example, if paying $30,000 in spousal support annually, how much is that $30,000 going to cost you after factoring in the tax deduction? And, if you’re receiving the $30,000, how much of that will you have to pay in taxes? For payments to qualify as spousal support, they must meet a number of requirements; talk to your lawyer or Certified Divorce Financial Analyst® (CDFA®) professional to make sure you’ve met them all.

Child Support

Generally speaking, child support is non-taxable income to the person receiving it and it is not tax-deductible by the person paying it. If you’re going to be paying both spousal and child support, you may be tempted to lump both payments together and call them “spousal support” so you can claim a bigger tax deduction. Sorry to burst your bubble, but the IRS and CRA are wise to this “strategy”, which could land you in serious hot water! You can also end up owing back taxes, penalties, and interest if your support payments are not structured correctly in your divorce agreement. In the US, if spousal support is reduced or terminated because of a contingency related to a child (such as a child attaining a specific age or income level, dying, marrying, leaving school, or gaining employment), it can be reclassified as child support. There are many other ways the IRS could reclassify some or all of the deductible spousal support you have paid as non-deductible child support; ask your CDFA professional to make sure your agreement doesn’t contain one of these hidden traps before you sign it.

Third-Party Payments

Usually, payments must be made directly to the recipient to be classified as support. But what if you’re going to be paying child or spousal support to an ex who has a genuine problem with money – a gambling addiction, for instance? “Third-party or specific-purpose payments can be considered support payments [under certain circumstances],” says Mary Krauel (CPA, CA, MBA, CDFA), who practices in Mississauga and London, Ontario. “Specific-purpose payments may include rent, property taxes, insurance premiums, and educational or medical expenses for the benefit of the recipient.” This is helpful in settlements where there is concern the support payments will be used by the recipient for necessary expenses while at the same time preserving the deductibility for the payor, she adds. “To guarantee deductibility – clearly state it in the agreement.”

Divorce-Related Fees

In the US, you can deduct the portion of fees paid to to divorce-industry professionals (e.g., lawyers, actuaries, accountants, or appraisers) for tax advice or for help in getting spousal support. In Canada, you can deduct legal fees paid to establish, increase, or collect support payments; however, only the recipient of support may claim these deductions – not the payor. Ask your CDFA professional or accountant whether you can deduct any of the divorce-related professional fees before you file your taxes.

Filing Status

“Filing status is often more important than dependency exemptions: someone filing as a Head of Household (HOH) can claim a higher standard deduction and lower tax rates than a single filer,” says Heather Smith Linton (CPA, CFP, CVA, CDFA), who practices in Durham, North Carolina. “This can often translate into more of a tax savings than a dependency deduction. A couple needs to have at least two children to make this strategy work,” she continues. “The general rule for filing as HOH is that an unmarried taxpayer would have to maintain a household that is the principal place of abode for over half the year for a qualifying child.” According to Justin Reckers (CFP, CDFA), who practices in San Diego, California, the HOH filing status strategy is a simple and elegant way to reduce overall tax bills and even has some other benefits. “HOH filing status comes with tax brackets identical to those available to the Married Filing Jointly scenario, but also allows for each party to the divorce to file separate tax returns,” he says. Talk to your CDFA professional or accountant about the requirements for claiming HOH to see if this strategy can work for you.

Joint Tax Returns

If you are still filing joint returns with your spouse, make sure to review your tax return before signing on the dotted line. “Remember – you will be held liable for what is being reported, whether your spouse or a professional accountant prepared the form,” warns Carlton R. Marcyan (JD, MBA, CPA, CFP, CDFA), a partner at Schiller DuCanto & Fleck in Chicago, Illinois. “In my nearly 25 years of practicing law, I would estimate that two out of three spouses do not look at their tax returns before signing and are not aware of what they are consenting to.”

Tax Credits and Benefits

Make sure you’re taking advantage of all possible tax credits and benefits during and after divorce; if your agreement isn’t structured correctly, you may be unable to claim tax relief. Karen Hallson-Kundel (CGA, CBV, CDFA), who practices in Winnipeg, Manitoba, points out that the separation agreement must specifically identify the parent who will claim the child in order to preserve the Eligible Dependant tax credit, for instance. “Families with two children can structure the separation agreement to indicate that each parent claims one child, effectively doubling the tax benefit,” she says. “Carefully planning this aspect of a separation agreement can save your family between $4,052 and $6,702 (depending on your province) for the 2012 tax year.” In the year of separation, get your CDFA or accountant to crunch the numbers to see whether you should be claiming the spousal support or any allowable tax credits. “If you pay support and you are were separated for only part of the year, you may claim either the deductible support paid that year or allowable refundable tax credits – whichever yields the larger benefit,” says Karen Archibald. “For example, Sally and Joe separated on September 1, and Joe pays Sally $300 each month in deductible support. Joe would be far better off claiming the spousal credit of $10,527 versus the support of $1,200.” Of course, there are different tax credits and benefits in the USA and Canada, so ask your CDFA professional about what is available in your area and for your situation.

The Fiscal Cliff

In the USA, the new tax laws will have a large impact on upper income earners and their divorce. The new laws bring back the phase-outs for Personal Exemptions and Itemized Deductions; The phase-outs begin at $250,000 for unmarried taxpayers. “For the past several years, the rule of thumb was to have the higher-earning spouse take the Personal Exemption for the children, since it was worth more to him/her,” says Jeff Kostis (CFP, CDFA, CPA/PFS), who has offices in Vernon Hills and Chicago, Illinois. However, the return to the phase-out changes this. “Now, if the higher-earning spouse takes the exemption for the children, the tax benefit may be lost if he/she earns more than $250,000 per year.” Similarly, many divorce decrees require the higher-earning spouse to pay the mortgage and real-estate taxes on the jointly-owned house used by their former spouse and children. “The payor spouse deducted part of the mortgage payment as alimony, part as an itemized deduction,” says Kostis. “In total, 100% of the payment was tax deductible. With the return of the Itemized Deduction phase-outs, the payor spouse may not get the full tax benefit from the itemized deductions. In these cases, the couple may be better off to increase the amount of alimony – which is fully tax deductible – and have no requirement as to the payment on the mortgage and real estate taxes.”