Finance Roll

I have come to the conclusion that the process of going through a divorce can oftentimes be, emotionally, more catastrophic than a death in the immediate family. That's a statement that is not easy to make, but I believe it is true. Ask anyone who is going through or having gone through a divorce and they will tell you it is or was the most stress they have ever experienced in their lives. I see this stress in the face of many of my clients. Divorce can break a person, plain and simple.

Next to personal bankruptcy its affects on your personal finances will take years to overcome. Most never do overcome the financial wreckage a divorce leaves behind. It is for this reason that anyone contemplating divorce seek out a competent tax advisor to help minimize the financial repercussions of a divorce. A good tax advisor, experienced in divorce tax planning, can better position you to recover from the divorce, financially. There are many pitfalls in divorce tax planning that can be avoided through thoughtful analysis and planning with your professional tax advisor. Anyone contemplating a divorce must meet not only with their attorney but also with their CPA or tax advisor.

I have encountered many instances in my practice where being left out of the planning process resulted in lost tax benefits, typically to the party making payments to their soon-to-be ex-spouse. Additionally, where separation occurs first, there are ways to formulate the separation agreement that enable the payor spouse to receive tax benefits for payments made to the recipient spouse during the period of separation.

In a divorce, there are typically three types of payments that are made between spouses. One is in the form of alimony, another is in the form of property settlements, and the third, if there are minor children, is in the form of child support.

Deductible Payments:
In order for amounts paid by one spouse to another spouse to be considered deductible, the amounts paid must be pursuant to either a legal separation agreement (called "separate maintenance payments") or a divorce decree (called "alimony"). In order for separate maintenance payments to be considered deductible, the separation must be considered a legal separation. In a legal separation there needs to be a formal separation agreement and neither spouse may live together in the same home. Additionally, a legal separation requires a court order governing what will happen while the parties are separated.

A legal separation is infinitely more complicated and more expensive than an informal separation. Like a legal separation, a divorce decree must be issued pursuant to a court order. There is a formal agreement setting forth the terms of the divorce. The payments must be made in cash and there is a three-year recapture rule that looks at the dollar amount of the payments made over a three-year period. As an example of this rule, if the payments made in years two and three are lower than the payment made in year one by $15,000 or more, than the year one payment is considered a property settlement and that deduction is recaptured (treated as taxable income to the payor spouse) in year three. Liability for separate maintenance payments or alimony must end upon the death of the recipient spouse.

Any cash payments made to third parties (i.e. mortgage or rent), pursuant to the separation agreement or divorce decree, qualify for separate maintenance payments or alimony. Legal fees paid for tax advice relating to the separation or divorce are deductible as itemized deductions. Legal fees relating to the drafting of the separation agreement or the divorce decree and legal fees related to child custody or child support are not deductible. The payor spouse is entitled to a tax deduction for the separate maintenance payments or alimony made, incident to a legal separation or divorce, and the recipient spouse is required to include such payments as income in their annual income tax return filing. Separate maintenance payments and alimony are considered "compensation" to the recipient spouse for IRA deduction purposes.

Non-Deductible Payments:
Property settlements represent a distribution of the ownership rights in property that one or both spouses have title to. This may be a home, an employer retirement plan or other assets created during the term of the marriage. In New Jersey, most assets created during the term of the marriage are split down the middle between both spouses in a legal separation or divorce. Property settlements are never tax deductible by the payor spouse and never considered taxable income to the recipient spouse.

They are considered tax-free exchanges if they are incident to the separation or divorce and transferred within one year. Qualified employer retirement plan money, generally, cannot be removed from the account of an employee spouse while the employee spouse still works there. A Qualified Domestic Relations Order ("QDRO") issued by the court as part of the legal separation or divorce decree is one of the few exceptions. In most cases, a QDRO is used to transfer money from the 401(k) of the payor spouse to the recipient spouse's IRA. However, the tax code also provides that the money being transferred under a QDRO can go directly to the recipient spouse without being subject to the 10% penalty tax.

These funds can then be used just as any other money in a savings account. Thus, this money can be used for immediate purposes, such as a house down payment. Adding further flexibility is the ability of the recipient spouse to have some of the QDRO money transferred to an IRA while the rest can be transferred directly to the spouse. While there is no tax penalty, the 401(k) money not rolled over directly into an IRA, will be subject to income tax in the year of receipt. Transferring IRAs or annuities of the payor spouse to the recipient spouse do not require a QDRO from the court. In the case where a home is sold after a legal separation or divorce, each ex-spouse is entitled to exclude up to $250,000 of the portion of the gain. This is true even where one spouse has moved out of the home and would not otherwise qualify for the exclusion.

Child support is never tax deductible to the payor spouse or taxable income to the recipient spouse. In no case will child support payments be considered separate maintenance payments or alimony.

I've tried to scratch the surface on the important tax issues surrounding a separation or divorce, but I cannot reiterate strongly enough the need to consult with a tax advisor experienced in divorce tax planning. A good tax advisor can identify the material weaknesses in the preliminary agreements with one to two hours of review time. Failing to plan in a divorce is tantamount to planning to fail and, thus, further encumber your ability to recover financially from this significant life event.