Income Issues in Divorce

By Dr. John L.Stancil
Tax Analyst, WebTaxCenter.com

When a couple goes through the divorce, a major area of concern should be the property settlement and related financial issues. A person who is a party to divorce proceedings should understand the terms of the settlement. This may mean that you should have counsel that can understand and explain the financial ramifications to you.

Property Settlements

When one party transfers property to the other party as a part of the divorce proceedings, there is normally no gain or loss on the transfer. A transfer is considered to be "incident to the divorce" if the transfer occurs within one year of the end of your marriage or is related to the ending of your marriage.

Even though there is no tax on the transfer, when the property is later sold for a gain, the owner will be liable for tax on the gain. When your ex-spouse transfers property to you, your cost basis is the same as the basis your former spouse had. For example, assume the husband purchased 100 shares of stock for $10 per share. At the time of the divorce, he gave stock to the wife, now valued at $15 per share. This is merely a transfer of title and does not create a taxable event. Later, the wife sells the stock for $17 a share. She will have a capital gain of $7 per share, reported on Schedule D of your 1040.

The transfer of an IRA by a spouse under a divorce decree is not a taxable transfer. However, the transfer must be a trustee-to-trustee transfer or a change in the account ownership. Funds cannot be withdrawn and then deposited in a new or existing IRA account. Once transferred, the IRA is subject to all the usual rules and regulations regarding withdrawals and contributions. The same rules apply to health and medical savings account transfers.

If one spouse sells property and distributes a portion of the proceeds to the other spouse as a part of the divorce proceedings, the selling spouse is liable for any tax on the gain. The distribution to the other spouse is not normally a taxable event.

Property settlements for couples living in community property states have some differences and the rules may vary from state to state.

Alimony

Alimony is payment to a spouse or former spouse under a divorce decree. Alimony is deductible by the payer and income to the payee. As a recipient of alimony payments, you are required to provide your ex-spouse with your social security number. The spouse paying the alimony must include the recipient's social security number on their tax return. Failure to do either of these will result in a $50 penalty.

Sometimes the payer may try to include as alimony items that are not alimony according to IRS rules. Specifically, the IRS has stated that five items are not considered alimony.

• Child support
• Noncash property settlements
• Payments that are a part of your spouse's community income.
• Payments to keep up the payer's property.
• Use of property.

In addition, the IRS has four additional requirements for what is alimony. Alimony must be paid in cash. Transfers of property, including a promissory note do not qualify. Second, payments can be designated as "not alimony." In order for this to be effective, the divorce decree must state that both parties agree that the payments are not deductible as alimony by the payer and not income to the recipient. Third, the spouses cannot be members of the same household. This means that they cannot live under the same roof. The final requirement is that the alimony payments terminate upon the death of either spouse.

There is an exception to the rule that states that alimony must be paid in cash to the other spouse. If the payments are made to a third party on behalf of the other spouse, the payments can qualify as alimony. Payments are treated as received by the spouse and then paid to the third party. These payments can be for medical expenses, housing costs, taxes, or tuition. There must be a signed, written agreement prior to the payment that the payments are intended by both parties as alimony.

There is a rather complicated provision in the law regarding a "recapture of alimony." If, in the first three years of making alimony payments, the amount you pay decreases by more than $15,000, you may have to report as income a portion of the previously deducted alimony.

Child Support

Payments designated as child support are not deductible by the person making the payments and they are not income to the one receiving child support payments. Usually the divorce decree will specify that certain payments are child support. In other cases, payments may not be designated as child support, but have characteristics of child support.

Payments not designated as child support will be considered as such if they are reduced by one of the following situations.

• An event relating to the child. Examples of relevant events would include the child becoming employed, dying, leaving the household, leaving school, marrying, or reaching a specified age or income level.
• Clearly associated with a contingency. Usually, this relates to the child attaining a certain age.

There are exceptions to this rule. If you can demonstrate that the reduction in payments was unrelated to any of the above events you may be able to classify them as child support.

If the spouse paying alimony and child support fails to make the required dollar amount of payments, the payments made are first applied to child support, then to alimony.

The tax and financial aspects of a divorce are not simple. For more information, you could consult IRS Publication 504 or go to www.webtaxcenter.com. If you have a complex financial situation, you should obtain the services of a qualified financial advisor. There are a number of CPA's as well as Certified Financial Planners who also hold the certification of Certified Divorce Planner. These individuals are trained to provide financial information and assistance to individuals and attorneys in divorce situations. This includes areas such as financial and tax implications, settlement options for dividing property, and provision of child support and spousal maintenance.

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Dr. John L. Stancil, a tax analyst for WebTaxCenter.com, has been a member of the Florida Southern College faculty since 1998. He received his bachelors degree from Mars Hill College and holds a M.B.A. from the University of Georgia. He later earned his doctorate in accounting from the University of Memphis. He holds four professional certifications, including CPA, CMA, CFM and CIA. Stancil has received the Florida Institute of CPAs 2005 Outstanding CPA in Public Service Award. (This award is given annually to a Florida CPA who has demonstrated significant contributions through community and civic activities.) He has also been recognized as the Expert of the Month on several occasions by allexperts.com.

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