US tax implications of divorce, what changes after you file

Divorce changes your taxes in ways that play out for years, at a time when you probably have little energy left for paperwork. Some of the rules changed in 2018, and plenty of people, including some advisors, still work from the old ones. Others are mechanical but easy to get wrong in expensive ways. Here is what changes and what to do about it.

Filing status in the year of divorce

Your filing status for a tax year depends on your marital status on December 31. If your divorce is final by December 31, you are unmarried for that whole year and file as single or head of household, even if you were married for eleven months of it.

If you are still legally married on December 31, even if you have been separated for a long time, you generally file married filing jointly or married filing separately. There is an important exception: under IRS rules you can be "considered unmarried" and file as head of household if you file a separate return, paid more than half the cost of keeping up your home, your spouse did not live in your home during the last six months of the year, your home was the main home of your qualifying child for more than half the year, and you can claim that child as a dependent (or could, except that you released the claim to the other parent).

Head of household is usually better than single or married filing separately. It has a larger standard deduction and wider tax brackets. Only the parent the child actually lived with for more than half the year can use that child to qualify.

Joint or separate in the last married year?

Filing jointly often produces a lower total tax, but both spouses are then jointly and severally liable for the whole tax on that return, including errors or unreported income from the other spouse. If you have doubts about your spouse's finances, filing separately may be safer. If a problem surfaces later on a past joint return, the IRS offers innocent spouse relief, separation of liability and equitable relief, requested on Form 8857.

Alimony and the 2018 rule change

This is the change that catches people off guard, especially those taking advice from someone who divorced before 2019.

• For divorce or separation agreements executed after December 31, 2018, alimony is not deductible for the payer and not taxable income for the recipient.
• For agreements executed before 2019, the old rules still apply: the payer deducts and the recipient reports the income. That continues unless the agreement is modified and the modification expressly says the new rules apply.

In practice, the payer now pays alimony out of after-tax income, so each dollar costs more than it used to for a high earner. That can reduce what a payer is willing to offer. Recipients, on the other hand, keep the full amount and do not need to budget for tax on it federally.

If you have a pre-2019 agreement and are changing it, be careful with the wording. A modification that does not expressly adopt the new treatment keeps the old rules. Some states have their own rules for state income tax, so check with a tax professional in your state.

Is child support taxable in the US?

Child support is not deductible for the payer and not taxable for the recipient. That has not changed.

Who claims the children after divorce?

The personal exemption amount is currently zero, so "claiming the child" no longer means a dependency exemption. It still matters for several valuable benefits. By default, the custodial parent, meaning the parent the child lived with for more nights during the year, gets them.

• Child Tax Credit: up to $2,200 per qualifying child under current IRS guidance, subject to income phase-outs. The custodial parent can release this to the other parent by signing IRS Form 8332, which the other parent attaches to their return.
• Credit for other dependents: also transferable with Form 8332.
• Child and dependent care credit: stays with the custodial parent. Form 8332 does not transfer it.
• Earned income credit: stays with the custodial parent.
• Head of household status: stays with the custodial parent.

Many parents alternate who claims the child year to year. That works for the child tax credit, using Form 8332, but not for the other benefits. Your agreement should say who claims which child in which years, that the custodial parent will sign Form 8332 by a set date, and whether that depends on support being current.

Retirement accounts: QDROs

Dividing a 401(k), 403(b) or pension requires a Qualified Domestic Relations Order (QDRO), a court order that tells the plan administrator to pay part of the account to the other spouse, called the alternate payee. Done correctly, the transfer is not taxed. The alternate payee pays tax when they eventually withdraw, just as the original owner would have.

One useful detail: a distribution paid to an alternate payee directly under a QDRO from an employer plan is exempt from the 10 percent additional tax on early distributions, although regular income tax still applies. That can help a spouse who needs cash now. Rolling the money into their own IRA keeps it tax-deferred, but later early withdrawals from the IRA lose that exemption.

Done incorrectly, for example if the account holder withdraws funds and hands them over, it is a taxable distribution to the account holder, plus a 10 percent additional tax if they are under 59½.

IRAs do not use QDROs. They can be divided by a transfer incident to divorce under the divorce decree or separation agreement, which is also tax-free when done directly between accounts.

A QDRO is a separate document from the divorce decree. Have it drafted by someone experienced, pre-approved by the plan administrator if possible, and entered by the court promptly. Delays cause real problems if the account balance changes, the plan changes, or the account holder dies or retires first. See pensions at separation for more.

Is there capital gains tax on the home after divorce?

Under IRC Section 121, a single filer can exclude up to $250,000 of gain on the sale of a main home, or $500,000 for a married couple filing jointly, if they meet the ownership and use tests: owned it and lived in it as a main home for at least two of the five years before the sale.

After divorce, each former spouse can claim up to $250,000 if they qualify. Two rules help divorcing couples:

• If your spouse or former spouse is allowed to live in the home under a divorce or separation instrument, you can count that time as your own use of the home, as long as you still own part of it. A spouse who moves out is therefore not automatically penalized while the other spouse stays on under the agreement.
• If the home was transferred to you by your spouse or former spouse, you can count their period of ownership as yours.

Make sure the right to stay in the home is written into the decree or separation agreement. An informal arrangement may not count.

Transferring the home from one spouse to the other as part of the divorce is generally tax-free under Section 1041. But the receiving spouse takes the original cost basis, so if the home has grown a lot in value, they could owe tax on gain above their own exclusion when they sell. Factor that into the property split.

Community property states

If you live in a community property state, such as California, Texas or Arizona, income earned during the marriage may have to be split between spouses on separate federal returns until the marital community ends under your state's law. IRS Publication 555 explains the rules. This can affect the year of separation significantly, so get advice if it applies to you.

Health insurance

A former spouse loses eligibility on the other's employer plan once the divorce is final. COBRA can continue that coverage for up to 36 months after divorce, but it is expensive: up to 102 percent of the full premium. Children can usually stay on a parent's plan. Losing coverage because of a divorce also opens a special enrollment period on the Health Insurance Marketplace, where premium tax credits may help. Read health insurance after separation for options.

What to do this week

1. Check where you will be on December 31: still married, or divorced. That determines your filing options.
2. Count nights each child spends with each parent this year, so you know who the custodial parent is for tax purposes.
3. Get your last three years of returns and an IRS account transcript, especially if you filed jointly.
4. Update your Form W-4 with your employer once your filing status will change, so you are not under-withheld.
5. If alimony is involved, confirm the agreement date, because 2018 and earlier agreements follow different rules.
6. Book a CPA who works with divorce for your first two or three tax years after separation. The fee is usually smaller than the mistakes it prevents.

Common questions

Is alimony taxable in the US?

Not under federal law for divorce or separation agreements executed after 2018. The payer cannot deduct it and the recipient does not report it. Older agreements keep the old rules unless modified to adopt the new treatment.

Can I file head of household if I'm separated but not divorced?

Possibly. You may be considered unmarried if you file separately, paid more than half the cost of your home, your spouse did not live there for the last six months of the year, and your child lived with you for more than half the year.

Who gets to claim the kids after divorce?

The custodial parent, meaning the one the child lived with for more nights, by default. They can release the child tax credit to the other parent with Form 8332, but head of household, the earned income credit and the dependent care credit stay with the custodial parent.

Is child support taxable?

No. Child support is not taxable to the recipient and not deductible for the payer.

Do we pay tax when we split a 401(k)?

Not if it is divided under a QDRO and transferred directly. Tax is paid later when the money is withdrawn. A direct QDRO distribution to the alternate payee is also exempt from the 10 percent early withdrawal penalty, though income tax applies.

This guide is legal information, not legal advice, and it is written for a general audience across Canada and the United States. Family law is provincial and state-based and changes over time. Before you rely on anything here for your own situation, confirm it with a qualified family lawyer in your province or state. FairWell can connect you with one through the professional directory.