Divorce | Family
What Divorce Expenses are Tax Deductible?
by Flora Tan
You may be able to deduct certain expenses related to your divorce from your taxes. Legal fees associated with the divorce proceeding, such as attorney fees, court fees, and fees for document preparation, are not tax deductible. You may deduct legal fees related to the collection of income, tax advice, business, and property.
As you navigate the path of separating your life from your former spouse, it is important to understand the tax implications of divorce, particularly the potential tax deductions that may benefit both parties.
Always consult with a tax professional or seek personal legal advice to ensure the most accurate and up-to-date information regarding your unique circumstances.
Tax Deductions vs. Tax Credits
To begin, it is crucial to differentiate between tax deductions and tax credits. Tax deductions reduce your taxable income, while tax credits directly reduce the amount of tax you owe. In other words, tax deductions lower your adjusted gross income (AGI), which in turn lowers the amount of income subject to taxation. Tax credits, on the other hand, directly reduce your tax liability, providing a dollar-for-dollar reduction in the amount of tax you owe.
How Tax Deductions Can Benefit Divorcing Parties
You may lower your overall tax liability by claiming tax deductions, thereby keeping more of your hard-earned money. During the divorce process, certain expenses may qualify as itemized deductions on your annual tax return. You may be able to deduct fees if they meet specific criteria outlined by the tax code of the Internal Revenue Service (IRS).
Exceptions for Tax-Deductible Legal Fees in Divorce Cases
As a general rule, personal legal costs are not tax deductible. This means that most of the legal or other expenses you incur during the proceeding, such as divorce attorney fees, court costs, and mediation costs, cannot be deducted from your annual tax return.
There are certain exceptions that may allow you to claim deductions for specific expenses. These exceptions typically apply when the legal fees are associated with the production or collection of taxable income or are related to a taxpayer’s profit-seeking activities.
Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, alimony or separate maintenance payments were generally tax-deductible for the payor and considered taxable income for the recipient. However, the TCJA made significant changes to the tax treatment of alimony. For divorce or separation agreements executed or modified after December 31, 2018, alimony payments are no longer tax deductible for the payor, nor are they considered taxable income for the recipient. These changes have shifted the tax burden from the recipient to the payor.
Qualifying for Alimony Tax Deductions
For divorce agreements executed before December 31, 2018, alimony payments may still qualify for tax deductions, provided they meet specific criteria outlined by the IRS. To be deductible, alimony payments must:
- Be made in cash, check, or money order.
- Be made under a separation or divorce agreement.
- Not be designated as non-alimony, such as child support or property settlement payments.
- Be made to a spouse or former spouse, not a third party.
- Cease upon the death of the recipient.
If the alimony payments meet these requirements, the payor can claim the deductions as an adjustment to their gross income on their annual tax return, without having to itemize deductions.
Tax Implications for the Payor and Recipient
For divorce agreements executed or modified after December 31, 2018, the payor can no longer deduct alimony payments, resulting in a higher taxable income and potentially a higher tax liability. On the other hand, the recipient benefits from these changes, as the alimony payments are no longer considered taxable income, effectively lowering their tax liability.
For divorce agreements executed before December 31, 2018, the tax implications remain the same as before the TCJA. The payor can deduct alimony payments, lowering their taxable income, while the recipient must report the alimony as taxable income, increasing their tax liability.
Division of Marital Assets
The way property is divided can have significant tax implications for both parties involved. Assets such as real estate, investments, and retirement plans can carry various tax liabilities, which can impact each party’s financial situation following the divorce. To ensure a fair and equitable division of assets, consider the tax basis, potential capital gains or losses, and any tax-deferred or tax-exempt status of each asset.
Capital Gains and Losses
Capital gains and losses occur when you sell or exchange a capital asset, such as stocks, bonds, or real estate. The difference between the asset’s sale price and its tax basis (usually the original purchase price) will result in either a capital gain or loss. In a divorce, the transfer of property between spouses or former spouses is generally considered a tax-free event.
However, when the recipient later sells the asset, they may be subject to capital gains tax based on the asset’s original tax basis. It can also be adjusted for various factors such as depreciation, improvements, or fees related to the purchase. For example, if you receive a piece of real estate in the divorce with a tax basis of $100,000 and later sell it for $200,000, you would be responsible for capital gains tax on the $100,000 gain.
Transfers of Retirement Assets and Tax Consequences
Retirement assets, such as 401(k) plans, IRAs, and pensions, are often significant components of a marital estate. To avoid immediate tax liabilities, retirement assets should be divided using a Qualified Domestic Relations Order (QDRO) or, in the case of IRAs, a court-approved transfer incident to divorce.
A QDRO is a legal document that allows retirement assets to be transferred between spouses without incurring taxes or early withdrawal penalties. The recipient spouse may either choose to keep the funds in a retirement account or roll them over into another qualified plan or IRA. If done correctly, the transfer may be tax-free, but the recipient will be responsible for any taxes upon eventual withdrawal.
For IRAs, a court-approved transfer incident to divorce allows funds to be transferred directly from one spouse’s IRA to the other spouse’s IRA without tax consequences. Similar to QDROs, the recipient will be responsible for any taxes upon eventual withdrawal.
Child Support and Tax Deductions
Unlike alimony, child support payments are not tax deductible for the payor, nor are they considered taxable income for the recipient. This means that the parent who pays child support cannot claim a tax deduction for these payments on their annual tax return, and the parent who receives child support does not need to report these payments as income.
The rationale behind this tax treatment is that child support payments are intended to provide for the child’s needs, and as such, they should not be subject to taxation. The parent paying child support is essentially providing financial support to the child in the same way they would if the parents were still together, so these payments are treated as a non-taxable expense.
Claiming Dependents After Divorce
After a divorce, only one parent can claim a child as a dependent for tax purposes. Generally, the custodial parent—the parent with whom the child spends the majority of the time—has the right to claim the child as a dependent.
However, the non-custodial parent may be able to claim the child as a dependent if both parents agree and meet certain requirements, including signing IRS Form 8332 (Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent). By claiming a child as a dependent, the parent can benefit from various tax deductions and credits.
Divorced parents need to communicate and come to an agreement regarding claiming dependents to avoid potential conflicts and complications with the Internal Revenue Service (IRS).
The Child Tax Credit and Its Impact on Divorced Parents
The Child Tax Credit is a valuable tax credit that can significantly reduce the tax liability of eligible parents. As of the 2021 tax year, the credit is worth up to $3,600 per qualifying child under the age of 6 and up to $3,000 per qualifying child between the ages of 6 and 17.
To be eligible for the Child Tax Credit, the child must meet certain requirements, including being a U.S. citizen, national, or resident alien, having a valid Social Security number, and living with the taxpayer for more than half of the year.
In the case of divorced parents, only the parent who claims the child as a dependent can claim the Child Tax Credit. This means that the custodial parent, or the non-custodial parent with the signed Form 8332, will be eligible to receive the credit.
Tax Deductible Divorce-Related Expenses
Some divorce costs may be deductible if they are necessary. This may include:
Appraisal fees may be tax deductible if they are incurred to determine the value of assets that will generate taxable income in the future, such as investments or rental property. For example, if you need to appraise a rental property to determine its value for a property settlement, the appraisal fees may be deductible as a miscellaneous itemized deduction.
Financial Planning and Tax Advice Fees
Fees paid for financial planning and tax advice related to the divorce may be tax deductible if they directly pertain to the determination of taxable alimony or the division of assets that will generate taxable income. These fees can be deducted as a miscellaneous deductions. However, it’s essential to differentiate between fees related to tax planning and those related to the overall divorce process, as the latter are not deductible.
Mortgage Refinancing Costs
Mortgage refinancing costs may be deductible if the refinancing is directly related to the divorce and results in the division of a marital home. In this case, the mortgage refinancing costs can be treated as deductible mortgage interest, subject to the standard rules and limitations for mortgage interest deductions.
Get Connected to an Unbundled Divorce Lawyer
Taxes and divorce are confusing, and when it comes to divorce, you may want to seek help from an attorney. Our network of lawyers offers pay-as-you-go services, so you only pay for the advice you need. The fees start as low as $500-$1500, depending on the complexity of your case.
Let us match you with a divorce lawyer in your local area who can help help you understand your divorce as a whole.