Tax Implications Of A California Divorce
Divorce is a significant life event that poses emotional, financial, and legal challenges. Beyond the emotional impact, divorcing couples must navigate the complex tax implications that arise from the dissolution of their marriage, particularly in California, where divorce laws and tax regulations have unique intersections. At Sullivan Law & Associates, we specialize in guiding individuals and families in Orange County through the divorce process and helping them understand the tax ramifications of various divorce-related matters. For assistance with your divorce and tax concerns, contact our award-winning family law firm today at 949-590-8100.
Understanding The Filing Status On Your Tax Return
If you are getting divorced but still legally married at the end of the tax year (December 31), you can choose to file jointly instead of separately, even if you’re physically separated. Both spouses must agree to this.
Filing jointly can lower your overall taxes and simplify dividing deductions and income while finalizing who gets what. However, there are risks. Both spouses are liable for the joint return, meaning the IRS can pursue either for unpaid taxes. An audit after divorce could also cause issues. If you doubt your spouse’s honesty in tax reporting or have a contentious divorce, joint filing may not be worth the risk.
If the divorce is finalized before the end of the tax year, you’ll need to file as “single” or “head of household.” Filing as head of household often lowers your tax rate but requires meeting certain criteria, like having a dependent in your care for over half the year. Consulting a knowledgeable tax professional is recommended for accurate filing.
Spousal Support (Alimony) & Child Support
Spousal support and child support each carry unique tax implications for both the payer and the recipient.
Spousal Support
The tax treatment of spousal support underwent significant changes starting January 1, 2019, due to the Tax Cuts and Jobs Act. For divorces finalized after this date, spousal support payments are no longer tax-deductible for the payer, nor are they considered taxable income for the recipient. However, this only applies to agreements established after 2018. Therefore, it’s crucial to thoroughly understand the specific terms of your divorce agreement.
Child Support
Child support payments carry no tax implications. They are neither deductible for the payer nor considered taxable income for the recipient. It’s crucial to distinguish child support from other types of financial assistance, as their tax treatments differ.
Capital Gains
When dividing marital property, not all assets are equal, and potential capital gains can play a significant role. While the transfer of property due to divorce is not taxable, there is no step-up in tax basis because of the divorce. For instance, if you receive stocks or property that have significantly appreciated during your marriage, you must consider the capital gains taxes that may be owed upon sale when determining the property’s value.
Similarly, if the marital home is sold during the divorce and the proceeds are split, the capital gains tax exclusion can be up to $500,000. In contrast, if one party retains the home, their maximum exclusion as an individual is only $250,000. A future sale may then result in capital gains taxes that could have been avoided initially.
Retirement Accounts
When dividing retirement accounts during a divorce settlement, it’s crucial to do so correctly to avoid unintended tax consequences. An IRA can be split tax-free if it’s handled as a transfer incident to divorce in the agreement. For accounts governed by the Employee Retirement Income Security Act (ERISA), such as a 401(k), a qualified domestic relations order (QDRO) is required to facilitate a similar tax-free transfer. Improper handling of these transfers could result in owing taxes and early withdrawal penalties on the distributed amounts.
Dependency Exemptions & Child Tax Credits
Parents going through a divorce in California frequently have questions about claiming dependency exemptions and child tax credits.
Dependency Exemptions
Before the tax law changes in 2018, dependency exemptions played a crucial role in lowering a taxpayer’s taxable income. However, these exemptions have been suspended until 2025. Typically, the custodial parent (the parent with whom the child resides for the majority of the year) claims the child as a dependent. Nevertheless, this arrangement can be negotiated between parents within the terms of a divorce agreement.
Child Tax Credits
The Child Tax Credit offers significant tax relief for eligible parents. Starting in 2021, the credit is partially refundable and can reduce your tax bill by up to $3,600 for each qualifying child under 6 years old, and $3,000 for each child aged 6 to 17. Typically, the parent who claims the child as a dependent is entitled to this credit. However, both parents must understand how it will be allocated to ensure clarity and compliance.
Marital Home & Mortgage Interest Deductions
In divorce proceedings, the marital home frequently stands as a substantial asset and a major point of contention.
Sale Of The Marital Home
If the marital home is sold as part of a divorce settlement, the couple may be eligible for the capital gains exclusion on the sale of a primary residence. In certain cases, each spouse can exclude up to $250,000 of capital gains from their taxable income.
Mortgage Interest Deductions
If a spouse keeps the marital home and continues to pay the mortgage, they can still deduct mortgage interest, provided they meet IRS eligibility criteria.
Seeking Guidance on California Divorce Tax Implications?
Navigating tax-related issues during a divorce can be complex, especially when disentangling finances. The more intricate your financial situation, the higher the risk of unforeseen tax pitfalls that could negatively affect you. At Sullivan Law & Associates, we specialize in complex property division, collaborating with financial experts to craft settlements that safeguard our client’s interests. Let us help you avoid costly mistakes and secure your financial future.