Tax Issues: 5 (More) Things Your Tax Clients Should Consider for Separation and Divorce

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Previously, we covered the most common tax considerations after divorce, including filing status, dependents, child support, and alimony. Here, we dive into five more topics your clients may need to know about when they are in the process of divorce or separation: withholdings, legal separation, property settlements, legal fees, and community property. 

Updating withholdings 

After a divorce is finalized, both parties should reexamine their withholdings. Usually, this means submitting a new Form W-4 to their employer. If the change in filing status means that they are currently withholding less than their new estimated tax liability at the end of the year, then they must furnish a new W-4 to [their] employer within 10 days after the date of the change. This is typically the case for anyone whose status changes from Married Filing Jointly to Head of Household or Single.  

Similarly, 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. 

Filing as legally separated  

Legally separated couples are still viewed as married couples by the IRS. Clients legally separated but not yet divorced must file as Married Filing Separately or Married Filing Jointly. Filing a joint return usually reduces overall tax liability, and many separated couples choose this option.    

Note that even if they are legally divorced when they file their return(s), if the divorce was not finalized by December 31 of the tax year, they must still file as a married couple (either jointly or separately). If a couple’s divorce was finalized before the end of the year, they must file individual tax returns. For more on filing options after divorce, including Head of Household status, refer to our original guide to filing taxes after divorce.   

Property settlements 

While reaching a property settlement in a divorce can be difficult, the resulting tax situation is usually fairly simple. Typically, “there is no recognized gain or loss on the transfer of property between spouses, or between former spouses if the transfer is because of a divorce.”  (Note: if your client or client’s former spouse is a nonresident alien, the transfer is likely taxable.) 

The gift tax can apply to some transfers of property between former spouses, but most transfers related to a divorce are excluded from the gift tax. 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. 

Legal fees 

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.  

Community property states 

Under community property law, most types of assets, income, and property belong equally to both parties in a “marital community.” This means income generated before the “marriage community” was officially dissolved must be split evenly between the two parties’ tax returns. 

If your tax clients live in one of the nine community property states listed below, they may need to claim community income on their separate tax returns: 

  • California 
  • Idaho 
  • Louisiana 
  • Nevada 
  • New Mexico 
  • Texas 
  • Washington 
  • Wisconsin 

In all of these states, a finalized divorce ends the marriage community, and in some, being legally separated or simply living separately will also end the marriage community. If you or your clients live in a community property state, make sure you’re familiar with the laws regarding when the marriage community ends. 

Also, be aware that there are special provisions for couples who lived separately all year and met other requirements. Under these provisions, they may be able to avoid treating many types of income as community income.  

For more details on these exceptions to community property law and other topics on tax and divorce, refer to IRS Publication 504, Divorced or Separated Individuals

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