US tax implications of divorce, what changes after you file

Divorce changes your tax situation in ways that play out for years. Some of those changes happened in 2018 and many people, and some advisors, are still operating on the old rules. Others are mechanical but easy to get wrong in ways that cost real money. Here's a clear account of what actually changes and why it matters.

Filing status in the year of divorce

Your filing status for any given tax year is determined by your marital status on December 31 of that year. If your divorce is final by December 31, you file as single or head of household for the entire year, even if you were married for eleven months of it. If you're still legally married on December 31, even if you've been separated for years, you're filing as married filing separately or married filing jointly.

Head of household is a better option than single if you qualify. You qualify if you're unmarried (or considered unmarried under tax rules), paid more than half the cost of keeping up your home, and your home was the principal residence of a qualifying child for more than half the year. Head of household gives you a larger standard deduction and lower tax rates than filing as single.

Only one parent can claim head of household status per child. If you and your former spouse both try to claim it based on the same child, the IRS will flag the conflict. The tiebreaker rules look at which parent the child lived with for more days during the year.

Alimony and the 2018 rule change

This is the change that catches the most people off guard, particularly those who rely on advice from someone who went through their own divorce before 2019.

Under the Tax Cuts and Jobs Act (TCJA), which took effect January 1, 2019:

• For divorce or separation agreements executed after December 31, 2018: alimony payments are not deductible for the payer and not taxable income for the recipient.
• For agreements executed before January 1, 2019: the old rules still apply, the payer deducts, the recipient includes in income, unless the agreement is modified and the modification explicitly states it will be subject to the new rules.

The practical consequence: if you're negotiating an alimony arrangement today, the income-shifting benefit that existed under the old rules is gone. The payer gets no deduction. The recipient pays no tax. This simplifies the negotiation in some ways, but it also means high-income payers have less incentive to offer higher amounts, they're no longer getting a partial offset through their tax return.

If you have a pre-2019 agreement and are modifying it, be very careful about what your modification document says. A modification that doesn't explicitly adopt the post-TCJA treatment keeps the old rules in place.

Child support: still no tax effect

Child support has never been deductible or taxable in the US, and the TCJA didn't change this. The payer doesn't deduct it. The recipient doesn't claim it. Period.

Who claims the children

The dependency exemption itself was eliminated by the TCJA, so "claiming the child" in the old sense is less meaningful than it used to be. But who claims the child still matters for:

• Child Tax Credit, worth up to $2,000 per qualifying child as of the 2024 rules (subject to income phase-outs). Only the custodial parent can claim this by default, though it can be released to the non-custodial parent using IRS Form 8332.
• Child and Dependent Care Credit, for childcare expenses, only the custodial parent can claim this.
• Earned Income Credit, only the custodial parent is eligible.
• Head of household filing status, tied to physical custody for more than half the year.

It's common for parents to alternate who claims the child year to year in their agreement. This works fine for the child tax credit (via Form 8332) but not for the other credits, which always stay with the custodial parent. Make sure your agreement specifies the arrangement clearly and understands which credits can and can't be shifted.

Retirement accounts: QDROs

Dividing a 401(k) or pension in divorce requires a Qualified Domestic Relations Order (QDRO), a specific court order that instructs the plan administrator to divide the account and transfer the designated portion to the alternate payee (the receiving spouse). Done correctly, this is a tax-free transfer. The receiving spouse takes on the tax basis and pays tax when they eventually withdraw, just as the original owner would have.

Done incorrectly, for instance, if the account holder withdraws funds and tries to transfer them, it's a taxable distribution, plus a 10% early withdrawal penalty if the account holder is under 59½. That's an expensive mistake.

QDROs apply to employer-sponsored plans (401(k), 403(b), pensions). IRAs use a different mechanism, a transfer incident to divorce, documented in the divorce decree, but the principle is the same: the transfer itself is tax-free if done correctly.

Note: QDROs require a separate legal document beyond the divorce decree. They need to be prepared by someone who knows what they're doing, reviewed by the plan administrator before the divorce is final if possible, and entered as a court order. Many people don't realize the QDRO needs to be prepared separately and delay doing it, which creates problems if the account balance changes or the plan administrator has moved to a new system.

The family home and capital gains

The home sale exclusion under IRC Section 121 allows a single filer to exclude up to $250,000 in capital gains from the sale of their principal residence, or $500,000 for a married couple filing jointly. After divorce, each former spouse is a single filer and each gets the $250,000 exclusion, but only if they meet the ownership and use tests (owned and lived in the home for at least 2 of the 5 years before the sale).

Timing matters. If one spouse stays in the home after separation, the other spouse may lose the use test if they haven't lived there for 2 years within the 5 years before sale. This affects how quickly the departing spouse can afford to wait before the home is sold. A CPA should model this before the agreement is finalised.

Transfer of the home between spouses as part of divorce is generally tax-free under IRC Section 1041. But the receiving spouse takes on the original cost basis, so if the home has appreciated significantly and they later sell it after the exclusion window closes, they could owe capital gains tax on the full appreciation.

Health insurance

Children's health insurance coverage doesn't automatically continue unchanged after divorce. The parent who carries the children on their employer plan needs to confirm this coverage can continue post-divorce (most plans allow it). If the children are dropped from one plan, they need to be added to the other parent's plan or enrolled in separate coverage. COBRA is an option for a former spouse who was covered under the other's employer plan, but it's expensive, 102% of the full premium for up to 36 months.

Work with a CPA who knows divorce

Not all accountants are up to date on the post-TCJA alimony rules. Not all of them know how QDROs work or how the home sale exclusion interacts with a deferred sale arrangement. For the first two to three tax years after divorce, work with a CPA who has specific experience with divorce taxation. The cost is almost always less than the errors they prevent.