Tax Planning and Divorce

Dan Foster, CPA, CFP®

Director of Financial Education

Last Updated
November 30, 2022

5 Important Considerations for Divorcing Couples

As if going through the emotional and financial challenges of a divorce isn’t already difficult enough, you must also consider how your divorce may impact your taxes. As you navigate your settlement, keep in mind the following tax considerations.

#1 – Selling the family home

If you and your ex decide to sell your shared home, you may be responsible for capital gains taxes. Typically, individuals can avoid paying capital gains tax on the first $250,000 of a home sale or the first $500,000 for married couples filing jointly, as long as one of the spouses has owned the residence and both resided there for at least two of the last five years.

If you sell the home after the divorce, you and your ex can each exclude up to $250,000 of capital gains, assuming you’ve fulfilled the two-year requirement noted above. If you haven’t met the two-year requirement, you may still be eligible for a reduced exclusion, the exact amount of which will depend on the portion of the two-year period the home was owned and occupied. For example, if you only owned and lived in the home for one year, you may be eligible to exclude $125,000 of gain.

If you take sole ownership of the house as part of the divorce settlement and decide to sell it several years later, you will likely be eligible to exclude a maximum of $250,000 (the time your ex-spouse owned the home is added to your ownership period for purposes of the two-year requirement).

#2 – Alimony and child support

For divorce agreements executed after 2018, alimony is no longer deductible by the paying spouse, nor are payments taxable to the receiving spouse. This simplifies the alimony process compared to previous years, when alimony was deductible for the paying spouse and subject to income taxes for the receiving spouse.

Similar to alimony payments, child support is not eligible as a deduction, nor is it taxable to the receiving spouse.

#3 – Retirement plan assets

Use caution when dividing retirement plan assets, as there could be significant tax consequences for making a wrong move. For example, if you sell out of your 401(k) in order to split the assets with your ex, you’ll be responsible for paying income taxes as well as an early withdrawal penalty if you haven’t yet reached age 59 ½.

The correct way to divide assets in an employer-sponsored retirement plan is by initiating a qualified domestic relations order (QDRO). A QDRO is a legal document issued by a court that grants an ex-spouse a percentage of the assets in the account. Once a distribution from the account is made, the ex-spouse is responsible for any taxes due on the amount he/she received.

#4 – Child tax credits

A dependent cannot be claimed by more than one taxpayer, and it’s important to understand how the IRS determines which parent is eligible to claim dependent children. Typically, the parent who has physical custody of a child is eligible to receive any applicable child tax credits. However, there may be certain circumstances in which it makes sense for the non-custodial parent to claim the credit, split the credit or alternate which parent receives the credit each year.

A qualified tax advisor can help you determine what strategy makes the most sense for your particular financial situation.

#5 – Tax filing status

A couple’s tax filing status is based on their marital status as of December 31 of any given year. If your divorce is not finalized by the end of the year, you will need to determine whether it makes more sense to file jointly or as married filing separately.

While filing a joint return may reduce the amount you owe in taxes, it also means that both spouses can be held responsible for paying any taxes as well as any associated interest and penalties. If there is a significant income discrepancy between the two spouses, filing jointly can put the lower-earning spouse at risk.

Filing separate returns allows each spouse to report his or her own income, exemptions, deductions, credits, etc. Using this approach, each spouse is responsible for his or her own tax obligations.

Once the divorce is final, it may make sense to file as head of household if you have custody of dependents who reside in your home as their main residence. Filing as a head of household often has tax advantages over filing single.

At Creative Planning, our team of professionals includes CPAs, attorneys, insurance specialists and money managers all equipped to help you navigate the challenges of divorce. We focus on providing you with a clear path forward by helping you to determine your financial need, gain an understanding of your options and make decisions that are in the best interests of you and your family. For help navigating your taxes following a divorce, or with any other financial matter, schedule a call with a member of our team.

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This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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