When advising clients who have recently been divorced or legally separated, it’s important to look beyond filing status and dependent claims. Several lesser-known tax considerations can significantly impact their returns. This article will cover five key topics you should review with clients who are filing after separation: legal separation and filing status, updating withholdings, property settlements, legal fees, and community property.
Filing taxes as a legally separated couple
If your client has a legal separation decree or maintenance agreement, the IRS generally no longer considers them married for tax filing purposes. If the divorce or legal separation was finalized before December 31st of the tax year, each spouse must file an individual tax return. In most cases, they will file as Single, unless they meet the qualifications for Head of Household, or have remarried before the end of the year.
If the divorce decree or separation maintenance was not finalized by December 31 of the tax year, the couple is still considered married for tax purposes and must file as either Married Filing Jointly or Married Filing Separately.
Confirm with your clients who will claim any dependents after the separation or divorce. This decision can affect eligibility for Head of Household status, which generally requires that the taxpayer:
- Pays more than half the cost of maintaining a home for the year.
- Has a qualifying dependent living with them for more than half the year.
For more on filing options after divorce, refer to our original guide to filing taxes after divorce.
When to update tax withholdings after a divorce or separation
Once a divorce or legal separation is finalized, both parties should review and adjust their withholdings. This typically means submitting a new Form W-4 to their employer. If the change in filing status means they are currently withholding less than their new estimated tax liability, then they must provide a new W-4 within 10 days of the change. This is especially important for clients moving from Married Filing Jointly to Head of Household or Single.
If your client is waiting for a divorce or separation to be finalized, consider adjusting their W-4 in advance to reflect the expected difference in filing status, income, or the number of dependents they will claim. This proactive step helps avoid under or over-withholding once their filing status changes.
Losing certain credits and deductions, such as the Child Tax Credit, Earned Income Tax Credit, or the higher standard deduction for joint filers, can significantly increase tax liability. As a tax preparer, you should forecast how these changes will affect your client’s overall tax situation and recommend higher withholding if needed to prevent surprises at tax time.
Note: If one or both of your clients are self-employed, they may need your help recalculating and updating their estimated tax payments after the divorce.
Tax implications of property settlements
Reaching a property settlement in a divorce can be challenging, but the tax rules are generally straightforward. In most cases, there is no recognized gain or loss on the transfer of property between spouses, or between former spouses if the transfer is because of divorce.
The gift tax generally does not apply to property transfers that are a part of a divorce. However, the gift tax may apply if one spouse voluntarily gives property or money outside the divorce agreement, or if either spouse is a nonresident alien.
Qualified retirement accounts, such as 401(k)s and pensions, usually require a Qualified Domestic Relations Order (QDRO) to transfer assets between spouses without triggering taxes or early withdrawal penalties. Without a QDRO, distributions may be treated as taxable income and could incur a 10% penalty. Make sure clients understand this requirement and complete the QDRO process promptly.
If the transfer occurred under a divorce decree or under a written agreement related to the divorce (i.e. that occurring within the three-year period of one year before the divorce and two years after), the gift tax will not apply.
Are legal fees in a divorce tax deductible?
Legal fees related to divorce are not tax deductible in most cases. However, there are some exceptions. Legal fees from a property settlement related to divorce can’t be deducted from taxable income, they can be added to the basis of the property, reducing any potential tax your client may owe on the property.
If a spouse pays for the legal fees of their ex-spouse and is not under any legal requirement to do so, the payments are considered a gift and are subject to the gift tax if they exceed the annual exclusion amount. Unless a special arrangement has been made, the donor is responsible for paying the gift tax.
Filing in community property states
Under community property law, most types of assets, income, and property belong equally to both parties. This means income generated before the “marriage community” was officially dissolved must be split evenly between the two parties’ tax returns.
If your clients live in one of the nine community property states listed below, they may need to report community income on separate tax returns:
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
A finalized divorce ends the marriage community, and in some, being legally separated or simply living separately can also terminate it. As the tax preparers, you should confirm state-specific rules regarding when the community ends.
The IRS provides exceptions for couples who lived apart for the entire year and meet certain conditions. Under these provisions, they may avoid treating income as community income. Review IRS Publication 555 and Publication 504 for details on eligibility and documentation requirements.
In community property states, the IRS may require Form 8958, Allocation of Tax Amounts Between Certain Individuals in Community Property States, to properly report income, deductions, and credits between spouses or former spouses.
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