Divorce and Taxes What New York Residents Need to Know

Going through a divorce is one of the most challenging and emotional experiences a person can face. In addition to questions about children, property and financial support, divorce can create significant federal and New York State tax consequences. Understanding those consequences before signing a settlement may help you avoid unexpected liabilities and make better-informed financial decisions.

Divorce attorneys can help structure the legal terms of a settlement, but individualized tax advice should come from a qualified tax professional. At Cole, Sorrentino, Hurley, Hewner & Gambino, P.C., we can work with you and, when appropriate, your accountant or financial advisor to address the legal and financial issues involved in your divorce.

How Divorce Affects Your Filing Status

For federal income-tax purposes, your marital status is generally determined on the final day of the tax year. If a final judgment of divorce or separate maintenance is entered by December 31, you generally cannot file a joint return with your former spouse for that year. You may file as single or, if all applicable requirements are satisfied, as head of household.

If the divorce is not final by the last day of the year, the IRS generally continues to treat the spouses as married. They may ordinarily file jointly or separately, although a person who is considered unmarried under federal tax rules may qualify for head-of-household status.

Head-of-household status requires more than having a child or paying child support. Among other requirements, the taxpayer generally must pay more than half the cost of maintaining the household, and a qualifying person generally must live in that household for more than half the year. Special rules apply to divorced or separated parents.

Claiming Children and Related Tax Benefits

Divorce agreements should address who may claim a child for applicable tax purposes, but federal tax law ultimately determines eligibility. Under the general federal rule, the custodial parent is the parent with whom the child lived for the greater number of nights during the year.

A custodial parent may be able to release a claim to certain child-related tax benefits to the noncustodial parent by signing IRS Form 8332 or a substantially similar document that satisfies federal requirements. However, releasing the child-related dependency claim does not transfer every benefit. Head-of-household status, the earned income tax credit and the child and dependent care credit have separate requirements.

The settlement should clearly address responsibility for signing and delivering any required tax forms, the years covered by the arrangement and what happens if a parent does not qualify for a particular benefit.

Child Support and Maintenance Tax Considerations

Child-support payments are generally not deductible by the paying parent and are not taxable income to the receiving parent for federal or New York State income-tax purposes.

Spousal maintenance, sometimes called alimony, requires closer attention because federal and New York State rules may differ.

Federal Treatment of Maintenance

For divorce or separation instruments executed after December 31, 2018, qualifying maintenance payments are generally not deductible by the payer and are not included in the recipient’s federal taxable income.

The older federal rules generally continue to apply to qualifying instruments executed before 2019. Under those rules, qualifying maintenance is generally deductible by the payer and taxable to the recipient. A post-2018 modification of an older instrument can adopt the newer federal treatment if the modification expressly provides for it.

New York State Treatment of Maintenance

New York has not fully adopted the federal treatment for applicable maintenance paid under post-2018 instruments. Under current New York rules, a recipient generally reports an addition modification for applicable maintenance received, while the payer may report a subtraction modification for applicable maintenance paid. These adjustments are currently reported using New York Form IT-225.

Because the federal and New York treatment can differ, divorcing spouses should not assume that maintenance has no tax consequences merely because it is not reported as taxable income on the federal return. A tax professional should review the specific agreement, its execution date and any later modifications.

Property Transfers and Carryover Tax Basis

Property transfers between spouses, or between former spouses when the transfer is incident to divorce, generally do not cause immediate recognition of gain or loss for federal income-tax purposes. However, a tax-free transfer does not necessarily eliminate the embedded tax liability.

The spouse receiving property generally receives the transferring spouse’s adjusted tax basis. This is known as carryover basis. As a result, two assets with the same current market value may have very different after-tax values.

For example, cash worth $200,000 generally does not carry the same future tax exposure as investments worth $200,000 that have a low cost basis and a substantial unrealized gain. The potential taxes, transaction costs and liquidity of each asset should be considered when evaluating a proposed property settlement.

Selling or Transferring the Marital Home

A sale of the marital residence may create a taxable capital gain. A qualifying individual may generally exclude up to $250,000 of gain from the sale of a principal residence. Qualifying married taxpayers filing jointly may be able to exclude up to $500,000, provided the applicable ownership, use and other requirements are satisfied.

Special rules may help separated or divorced spouses satisfy the ownership or use requirements. For example, a person who receives the home from a spouse or former spouse may be able to count the transferor’s ownership period. A spouse who no longer occupies the home may, in certain circumstances, count the former spouse’s continued use when that occupancy is authorized by a divorce or separation instrument.

The exclusion applies to gain, not the total sale price. Adjusted basis, qualifying improvements, selling expenses, prior exclusions, depreciation and the timing of the sale can all affect the result. These issues should be reviewed before the agreement determines whether and when the home will be sold.

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Dividing Retirement Accounts

Retirement accounts require careful handling. The correct method depends on the type of account, the governing plan and the terms of the divorce settlement.

Many employer-sponsored qualified retirement plans, including certain pensions and 401(k) plans, require a Qualified Domestic Relations Order, commonly called a QDRO. A properly prepared QDRO can direct the plan to pay an assigned portion of the participant’s benefits to a spouse, former spouse, child or other dependent.

A QDRO does not ordinarily divide an individual retirement account. An IRA should generally be transferred under a divorce decree or qualifying written instrument using procedures that comply with the applicable tax rules. Simply withdrawing money and giving it to a former spouse can cause income taxes and possible early-distribution penalties.

The spouse who ultimately receives a taxable retirement distribution will generally be responsible for the resulting income tax, subject to the applicable plan and tax rules. The settlement should account for this future tax burden when comparing retirement assets with cash or other property.

Joint Tax Returns and Existing Tax Liabilities

Spouses who sign a joint federal income-tax return are generally jointly and individually responsible for the tax, interest and penalties associated with that return. This is commonly called joint and several liability.

A divorce agreement may allocate responsibility for a tax debt between the spouses, but that allocation does not necessarily prevent the IRS or New York State from seeking payment from either person who remains legally liable. The agreement may instead provide a contractual right to reimbursement from the spouse assigned responsibility for the debt.

Federal relief may be available through innocent-spouse relief, separation-of-liability relief or equitable relief. Eligibility involves multiple statutory requirements and is not established merely by stating that one spouse did not know about the unpaid tax. Requests are generally made using IRS Form 8857 and are evaluated according to the surrounding facts.

New York also has procedures concerning relief from joint tax liability. Anyone facing a substantial joint liability should promptly consult a qualified tax professional or tax attorney because filing deadlines may apply.

Should You File a Joint Return During the Divorce?

If spouses remain legally married at the end of the year, filing jointly may reduce their combined tax, but it can also create joint liability. Before agreeing to a joint filing, the parties should consider reviewing the completed return, supporting documents, refunds, balances due, estimated payments and any questionable positions.

A divorce agreement can address who prepares the return, who reviews it, how any refund or liability will be allocated and how the parties will respond to an audit. Neither spouse should sign a return without understanding the information reported on it.

Tax Planning After Divorce

After a divorce or separation, consider reviewing:

• Your federal Form W-4 and New York withholding elections
• Estimated tax-payment obligations
• Your filing status and eligibility to claim children
• The tax basis of assets received in the divorce
• Beneficiary designations and estate-planning documents
• Retirement-plan and IRA records
• Health-insurance coverage and related tax credits
• Your legal name and address on tax records, if either changed

Current federal Form W-4 no longer uses withholding allowances. A change in filing status, dependents, income or deductions may require a new withholding calculation.

Get Legal and Tax Guidance Before Finalizing Your Divorce

Tax consequences can significantly affect the true value of a divorce settlement. Filing status, maintenance, the marital home, investment basis, retirement benefits and joint tax liabilities should be evaluated before the agreement is finalized whenever possible.

At Cole, Sorrentino, Hurley, Hewner & Gambino, P.C., our attorneys help clients address the legal and financial issues involved in New York divorce. We can also coordinate with your accountant, tax attorney or financial advisor when specialized tax analysis is needed. Contact us to schedule a consultation.

To learn more, read: The Role of a Financial Advisor in a New York Divorce