Divorce and Income Taxes – End of Year Considerations

It’s that time of year when your mailbox is full of holiday greetings and heartfelt wishes as well as year-end tax planning tips.  Such year-end tips do not often touch on divorce related issues, which, unfortunately, are relevant and important to those impacted by this life event.

Many important divorce taxation considerations can happen at any time during or after the marriage, but one question of utmost importance is what filing status choices are available for the year of divorce and thereafter (before remarriage) and what filing status choices are available during years when the divorcing couple is still married?  Marital status is determined as of the end of the year (i.e. as of December 31st for calendar year end tax filers).

Filing Status & Amending Returns

One of the most important, if not the most important concept to remember for years when the divorcing couple is still legally married answers the question – can I amend the return to change the filing status?  The answer, as is so often the case, is – it depends. 

If Form 1040 is initially filed as Married Filing Separate (“MFS”), then the divorcing couple can, as a general rule, file an amended return to change to a Married Filing Joint (“MFJ”) return.  The couple has three years from the original due date for filing the return for such taxable year (without regard to any extension of time granted to either spouse) to amend to change from MFS to MFJ.  There are certain exceptions when complicating factors exist, such as after either spouse has commenced a lawsuit for the recovery of any part of the tax for such taxable year, or after a notice of deficiency has been mailed to either spouse for such taxable year and the spouse has filed a petition with the Tax Court.  As a practical matter, the future cooperation of both spouses is required.

If Form 1040 is initially filed using MFJ status, then the couple cannot switch to MFS status for that year after the due date for the return has passed.  A limited exception for the executor of a deceased spouse exists under which the executor has one year from the due date to change the deceased spouse’s return from MFJ status to MFS status, but only when the executor was appointed after the joint return was filed and neither the deceased spouse or the executor signed the MFJ return.

Using MFJ status usually saves taxes for a married couple when one spouse earns significantly more taxable income than the other. Using MFS status sometimes provides an overall tax savings where one spouse is able to claim more itemized deductions by filing separately (medical expenses, casualty losses, etc.).

If a decree of divorce has not been received as of the last day of the tax year and the taxpayer fails to qualify as “married but living apart from your spouse”, then the taxpayer is considered married for tax purposes and must therefore file either MFS or MFJ.  A married individual who qualifies as “married but living apart from your spouse”, however, is eligible for Head of Household (“HOH”) filing status, which is otherwise generally not available until after the divorce decree has been received. 

To qualify for HOH filing status all three of the following conditions must be met:

  1. The taxpayer is unmarried at the end of the year or treated as unmarried for tax purposes (which includes married but living apart from your spouse);
  2. The taxpayer maintains a home for an unmarried qualifying child, or a married child or other relative who can be claimed as a dependent, and that home is the child’s or relative’s principal place of abode where they live with the taxpayer for more than half of the year (an exception is that a dependent parent does not have to live in the same home as the taxpayer); and
  3. The taxpayer pays more than half the cost of maintaining that home for the tax year.

 A custodial parent (subsequent to divorce) does not have to be able to claim an unmarried child as a dependent in order to be eligible for head of household filing status as long as the child otherwise meets the definition of a qualifying child.  In almost all circumstances, a married child must be a dependent.

To be considered married but living apart from your spouse (prior to divorce) all four of the following conditions must be met:

  1. The taxpayer lives in a separate residence apart from his or her spouse for the last six months of the tax year;
  2. The taxpayer files a separate tax return (i.e. not MFJ);
  3. The taxpayer pays more than half the cost of maintaining the separate residence; and
  4. The taxpayer’s household is the principal home of a dependent child for more than six months of the year and the taxpayer is eligible to claim the child as a dependent (this is met if the taxpayer is entitled to claim the child as a dependent even if taxpayer waives that right in favor of the noncustodial parent and does not actually claim the child as a dependent on the tax return).

HOH tax brackets are more favorable than MFS tax brackets and filing as HOH can provide additional tax benefits in certain circumstances such as claiming the standard deduction even if the other spouse itemizes deductions or having higher phase out thresholds for various tax deductions and credits.

Innocent Spouse Rules & Separate Liability Relief

If one spouse suspects the other is not reporting a sizable amount of taxable income or is otherwise evading taxes, then MFS should be selected to avoid liability for unpaid taxes due on a joint return, as well as interest and penalties.  A truly unaware spouse may be able to avoid liability under the innocent spouse rules if the IRS or courts believe it inequitable to hold the innocent spouse liable for the tax.  It can be difficult, however,  for the spouse seeking relief to demonstrate that he or she had no reason to know of the tax understatement.  All the facts and circumstances will be taken into account by the IRS and the courts, including that spouse’s education level, business experience, and whether there was a failure to ask about items on a joint return or omissions from the return that a reasonable person would have asked.  The IRS and courts will also consider the extent to which the spouse seeking relief benefitted from the tax underpayment and, accordingly, it is possible to be held liable for the underpayment even where the taxpayer successfully demonstrated he or she did not know or have reason to know that the tax was understated – if the tax payer benefitted by virtue of a high standard of living.  As it is facts and circumstances based, partial relief may sometimes be granted for a portion of the understatement where the taxpayer may have had reason to believe there was some understatement but did not know or have a reason to know of a portion of it.  When no longer married, or when the spouses have not lived together for more than one year, a spouse with no knowledge of the income or expense items giving rise to a tax deficiency the IRS is trying to collect may be able to avoid or limit liability by filing Form 8857 to request separate liability relief.  The taxpayer filing Form 8857 must be able to explain which items giving rise to the tax understatement are allocable to the other spouse.

Dividing Income & Deductions for the Year of Divorce

Since they are not able to file using MFJ or MFS status for the year in which the divorce decree is received, the income and deductions for the period of time before the marriage ended must be apportioned between the spouses for tax reporting purposes.  The rules for community property states differ considerably from equitable distribution states.  Since New York is an equitable distribution state only the rules for equitable distribution states are discussed in the paragraphs that follow.  

In an equitable distribution state, the general rules for apportioning income are (a) earned income is taxable to the person who earned it, and (b) income from property is taxable to the property’s owner or owners.  When owned as joint tenants, tenancy by the entirety, or for a 50% tenancy in common the income is taxed one-half to each spouse. 

The spouse who pays for a deduction with a separately titled account is generally entitled to that deduction even if the funds in the account are considered marital pursuant to the divorce law of the state.  Deductions paid from a joint account are presumed to be paid half by each spouse, but the presumption may be rebutted if one spouse can establish that he or she alone paid the expense since the joint funds were sourced by that spouse.   Amounts expended that give rise to a tax credit are similarly treated, and the credit is allocable to the spouse whose funds were expended.

Joint estimated tax payments made before divorce may be divided in any manner deemed agreeable to both spouses, but if they cannot agree they are divided in proportion to each spouse’s separate tax liability.  The same is true for an overpayment from the prior year that is credited to the year when divorce occurs.  Since the IRS at first may simply post the payments and overpayments equally, it is good practice to attach a schedule to each of the ex-spouse’s tax returns that details the estimated tax payments and explains the allocation between the spouses and to also memorialize the agreed upon allocation in the divorce decree or settlement agreement.

As soon as significant problems with the relationship are encountered, it is advisable for each spouse to make any estimated tax payments that may be required using the taxpayer’s individual social security number rather than a joint voucher.  While married, the estimated payments can still be claimed on a MFJ tax return but use of separate vouchers will help the couple avoid processing issues if separate returns are filed.

Child Tax Credit

The custodial parent is generally entitled to the child tax credit, but if all other qualification rules are met, the noncustodial parent may claim the Child Tax Credit of $2,000 per eligible child, when the custodial parent has released the ability to claim the child as a dependent to the noncustodial parent by means of Form 8332 (Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent) or by written declaration on another document that conforms to the substance of Form 8332.  A copy Form 8332 or the substitute written declaration should be attached to the tax return when filed (preferably to the tax return filed by each spouse).

Home Mortgage Interest and Real Estate Taxes

In the year of divorce, interest expense and real estate tax expense of a jointly owned home is apportioned between the two owners.  As with other expenses, in an equitable distribution state, the spouse who pays the expense from a separately titled account is entitled to that deduction and deductions paid from a jointly titled account are presumed to be paid half by each spouse, but the presumption may be rebutted if one spouse can demonstrate that he or she alone contributed the funds to pay the expenses.

The allocation rules create difficulties when the spouses do not live together until legally divorced as well as after the date of divorce.  Although a spouse who does not occupy a residence but pays the mortgage is generally not entitled to a tax deduction for interest since the home is no longer his or her principal residence, use by one spouse can be attributed to the other spouse under the rules for deducting interest on a second home until they are divorced if they agree to do so.  Subsequent to divorce, if a child of the marriage lives there, the child’s use can sometimes be attributed to the nonresident spouse and qualify it as his or her second residence for an additional period of time.

For divorces finalized after December 31, 2018, when one ex-spouse owns and lives in the residence, but the other ex-spouse must pay the expenses, the paying spouse receives no deduction for these payments.  The recipient spouse is eligible to deduct payments as itemized deductions to the extent they represent mortgage interest and real estate taxes.  In this situation both the interest expense and real estate tax payments made by the non-occupant spouse are viewed as alimony to the occupant spouse (even though the alimony is not deductible), and the occupant spouse is then treated as having paid the deductible interest and real estate taxes (subject to other applicable limitations such as the $10,000 state and local tax itemized deduction cap). 

The determination of whether a home is a residence for purposes of the mortgage interest deduction is based on the rules for the exclusion of gain on the sale of a principal residence, which treat a taxpayer as using a property as a residence during any period of ownership that the individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument.  Accordingly, a non-occupant spouse can claim a mortgage interest expense deduction for payments made on a residence occupied by a current or former spouse, but who gets the deduction and the apportionment between the spouses depends on how the home is owned and who makes the payments.

When the non-occupant spouse makes all payments and the home is owned solely by the non-occupant spouse, the non-occupant spouse can claim all of the mortgage interest as a deduction, up to the applicable limits.   When the non-occupant spouse makes all payments and the home is jointly owned by both spouses, they each can claim one-half of the mortgage interest as a deduction, up to the applicable limits.

For real estate taxes, the determination of which ex-spouse can claim the itemized deduction for a residence that is occupied by one of them also depends on who makes the payments and how the home is owned, but the rules are different than those applicable for the mortgage interest deduction. 

Subject to the $10,000 limitation, if real estate taxes are paid by a spouse who has sole ownership of the home, they are deductible by the spouse who made the payment.  If the non-occupant spouse solely owns the home and the other spouse makes the payments, then the payments are treated as alimony (even though alimony is not deductible for agreements entered into after 2018) to the non-paying spouse and the non-paying spouse can claim a tax deduction for the payments.  If the home is owned jointly and both spouses make payments of real estate taxes, then each spouse can claim a deduction for the payments he or she made.  If the home is owned jointly (or as tenants by the entirety) and one spouse makes all the real estate tax payments then the paying spouse can claim a deduction for all of the taxes paid (in this case the payments are treated as being made to protect the ownership interest of the paying spouse and no portion of them is treated as alimony to the other spouse).  If held as 50% tenants in common and one spouse makes all the real estate tax payments, then each spouse can deduct half the real estate taxes.

It is best to structure spousal maintenance (which is no longer deductible) and who will make payments associated with a residence after divorce to allow for deductibility of interest and real estate taxes (subject to applicable limitations) and otherwise plan to maximize the tax benefits associated with home ownership until the property is sold, gifted, or bequeathed.  A number of factors come into play.  For example, it is more beneficial for deductible interest and taxes to be arranged so that a spouse who can potentially use them is entitled to claim the deduction as opposed to a spouse who cannot because of appliable limitations or a spouse whose itemized deductions will not exceed his or her standard deduction.

A clean break, whereupon the occupant spouse buys out the other (i.e. receives the property pursuant to equitable distribution)  and refinances or where the residence is sold to a third party and a new residence is purchased, is frequently viewed as easiest and best for a number of reasons, but when a residence continues to be owned by both ex-spouses or by the non-occupant spouse some mortgage interest expense or real estate tax payments may continue to be deductible, depending on the particular circumstances.

Tax Carryforwards

Most taxpayers file jointly while married and the final MFJ tax return may contain various tax carryforwards.  Those carryforwards must be apportioned between the ex-spouses for use in the year when the divorce decree is received and thereafter. 

As a general rule, capital loss carryforwards are apportioned to each spouse based upon each spouse’s individual capital losses giving rise to the carryforwards, with gains or losses on jointly owned property divided equally between the spouses.

As a general rule, a charitable contribution deduction carryforward is apportioned in the ratio of what the MFS carryforwards would have been had the spouses filed separately for the year(s) in which the carryforward arose.

A carryforward net operating loss (NOL) depends on who generated the NOL.  If the NOL was generated by one spouse, then the carryover is available only to that spouse.  If the NOL was generated partially by each of the spouses, then the carryover is apportioned between the spouses in the ratio of what the NOL carryforwards would have been if MFS returns had been filed.

There is no current guidance as to how to apportion a minimum tax credit carryforward, whether an excess business loss carryforward would follow the award of the business interest or be subject to the NOL rules, or how to apportion investment interest expense carry forwards or certain other items.  Where guidance is lacking, and the ex-spouses have agreed upon an allocation, it should be documented in writing. 

Closing Thoughts

Deciding which filing status to choose and weighing non-tax factors as well as and planning to avoid  paying any more income taxes than necessary can be a complicated process for a divorcing spouse, which adds additional stress to an already difficult situation.

Discussing the options available with the divorcing couple’s tax preparer(s) and quantifying the tax costs or tax savings associated with each alternative can help each spouse make the decision they feel most comfortable with and, if they are feeling stressed, help to alleviate some of their stress. 

CPA’s well versed in the complications associated with divorce can help taxpayers and their divorce attorneys understand the effects of alternative courses of action, resolve issues, consider settlement agreement indemnification clauses or other settlement agreement provisions that may be appropriate for the circumstances, or provide other tax planning services.