Divorce and the New Tax Law Brings a Plethora of Tax Planning Decisions

Article Highlights:

• Filing Status 
• Claiming the Children as Dependents
• Child Exemption 
• Head-of-Household Filing Status 
• Tuition Tax Credit 
• Child Care Tax Credit 
• Child Tax Credit 
• Medical Insurance 
• Earned-Income Tax Credit 
• Alimony 

If you are recently divorced or are contemplating divorce you will have to deal with or plan for significant tax issues such as asset division, alimony, and tax-return filing status. If you have children, additional issues include child support; claiming of the children as dependents; the child, child care, and education tax credits; and perhaps even the earned-income tax credit (EITC).

Filing Status – Your filing status is based on your marital status at the end of the year. If, on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or to each submit a return as married filing separately. There is an exception to this rule however; if a couple has been separated for all of the last 6 months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child, then that spouse can use the more favorable head-of-household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must have the status of married filing separately. If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.

Claiming the Children as Dependents – A common (and commonly misunderstood) issue for those who are divorced or separated and who have children is the choice regarding who claims a child for tax purposes. This can be a hotly disputed issue between parents; however, tax law includes very specific (albeit complicated) rules about who profits from child-related tax benefits. At issue are a number of benefits, including the child, child care credit, higher-education tuition, and earned-income tax credits, as well as, in some cases, filing status.

This is actually one of the most complicated areas of tax law, and both taxpayers and inexperienced tax preparers can make serious mistakes when preparing returns, especially if the parents are not communicating well. When parents cooperate with each other, they often can work out the best tax result overall, even though it may not be the best for them individually, and can then compensate for discrepancies in other ways.

When a court awards physical custody of a child to one parent, the tax law is very specific in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support that the other parent provides. However, the custodial parent may release this dependency to the noncustodial parent by completing the appropriate IRS form.

CAUTION – The decision to relinquish dependency should not be taken lightly, as it impacts a number of tax benefits.

On the other hand, if a court awards joint physical custody of a child, only one of the parents can claim the child for tax purposes. If the parents cannot agree on who will claim the child and the child, or if both actually claim the child, the IRS tiebreaker rules apply. Per these rules, a child is treated as a dependent of the parent with whom the child resided for the greater number of nights during the tax year; if the child resides with both parents for the same amount of time, the parent with the higher adjusted gross income claims the child as a dependent.

Child’s Exemption – Under prior law, a child’s tax-exemption deduction ($4,150 in 2017) was generally an issue; the parent claiming the child as a dependent claimed the exemption allowance. However, because of the recent tax reform, the tax deduction for such exemptions has been suspended through 2025; although this is no longer an issue for this benefit, a child’s dependency is still a consideration for other tax issues.

Head of Household Filing Status – An unmarried parent can claim the more favorable head-of-household (rather than single) filing status if that person (a) is the custodial parent and (b) pays more than one-half of the cost of maintaining the household that acts as the principal place of residence for the child (i.e., where the child lives for more than half of the year).

Tuition Credit – If the child qualifies for either of two higher-education tax credits (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit goes to whoever claims the child as a dependent. Credits are significant tax benefits because they reduce the dollar-for-dollar tax bill; deductions, on the other hand, reduce taxable income before the tax amount is calculated according to the individual’s tax bracket. For instance, the AOTC provides a tax credit of up to $2,500, 40% of which is refundable. However, both education credits phase out for high-income taxpayers. For instance, the AOTC phases out between $80,000 and $90,000 for unmarried taxpayers and between $160,000 and $180,000 for married taxpayers.

Child Care Credit – A nonrefundable tax credit is available to the custodial parent to offset the cost of child care, provided that the parent is gainfully employed or seeking employment. To qualify for this credit, the child must be under the age of 13 and be a dependent of the parent. However, there is a special rule for divorced or separated parents; when the custodial parent releases the child’s exemption to the noncustodial parent, the custodial parent still qualifies for the child care credit, and the noncustodial parent cannot claim that credit.

Child Tax Credit – A credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds the tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents and at $400,000 for married parents filing jointly.

Medical Insurance – Parents must keep in mind that, under the Affordable Care Act, if a child does not have medical insurance during any part of the year, the parent who claims the child as a dependent is the one who is responsible for any applicable penalties. This is only an issue for the years 2014 through 2018, as the recent tax reform eliminated the penalty for subsequent years.

Earned-Income Tax Credit – Low-income parents with earned income (either wages or self-employment income) may qualify for the EITC, which is based on the number of children (all those under age 19, plus full-time students under age 24), up to a maximum of three children. Releasing dependency to the noncustodial parent does not disqualify the custodial parent from using children to qualify for the EITC. In fact, the noncustodial parent is prohibited from claiming the EITC based on children whose dependency the custodial parent has released.

Alimony – The recent tax reform also impacts the tax treatment of alimony. For divorce agreements that were finalized before the end of 2018, the recipient (payee) of the alimony must include that income for tax purposes. The payer in such cases is allowed to deduct the payments above the line (without itemizing deductions); this is technically referred to as an adjustment to gross income. The recipient who includes this alimony income can treat it as earned income for purposes of qualifying for an IRA contribution, thus allowing the recipient to contribute to an IRA even if he or she has no income from working.

Because some of those who make alimony payments will claim that they paid more than they actually did, and because some recipients will report less alimony income than they actually received, the IRS requires that the paying spouse’s tax return include the recipient spouse’s Social Security number so that the IRS can use a computer to match the amount received to the amount paid.

For divorce agreements that are finalized after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income for the purposes making an IRA contribution.

This revised treatment of alimony also applies to any divorce or separation instrument that is executed before the end of 2018 but modified after that date – if the modification expressly provides that the tax reform provisions apply.

As you can see, some complex rules apply to divorce situations. Please consult this office if you have any questions related to a pending divorce action. Please note that, if this office has been providing services to both parties in a pending divorce, there are some inherent conflicts of interest in providing advice or preparation services to both parties, so this office may be able to provide services to only one member of the former couple.

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