Taxes may not be the most important issue for unhappily married couples in the midst of breaking up, but the stakes are high and penalties can be severe when couples underestimate how a life-altering change such as divorce can affect what they owe Uncle Sam.
"It's bad enough to have to think about taxes, but when you have to do it while going through a marital breakup, that's the ultimate insult to injury for a lot of people," said Kay Bell, a contributing tax editor for Bankrate.com, headquartered in North Palm Beach, Fla.
One of the first issues people face when they are separated, but not yet divorced, is their filing status.
For tax purposes, it is a person's status on Dec. 31 of the tax year that is definitive. Taxpayers who are not divorced on that date must continue to use one of the options offered to married couples -- married filing jointly or married filing separately.
"What very often happens is the couple may have been filing joint returns for many years. Now they are not very fond of each other and want to file separately," said Jackie Perlman, principal tax analyst at H&R Block in Kansas City, Mo.
"They should consider filing a joint return even if there is relationship strife," Perlman said. "They will reap more tax benefits than they would filing married but separate."
If a couple is married filing separately, they are unable to take any education credits -- worth up to $2,500 -- if either spouse or any of their children are still in college. They also can't take advantage of a deduction that working parents receive for child care costs. Nor can they deduct student loan interest.
Married couples filing separately also lose the deduction for passive losses they may have on rental property and the non-working spouse would even lose the ability to take an IRA deduction.
New York-based Michael Rosedale, president of CPA Directory, a national directory of certified public accountants, said divorcing couples must be careful to avoid letting emotions take over when they could save money by filing jointly.
"A lot of spouses are so hostile with each other that even though it makes economic sense to file jointly, they file separately," Rosedale said.
High unemployment rates and depressed housing markets in some areas of the country have forced many divorcing couples to continuing living under the same roof simply because they cannot afford to maintain two separate households.
But if separated couples do not live in the same home and have not lived together for at least six months, the spouse living with the child or children can file his or her income tax return as head of household.
"The tax bracket is more favorable for head of household," Rosedale said. "People who file head of household don't lose the deductions they would lose by filing separately as a married couple."
Another common issue that comes up is determining which parent will get to use the children as exemptions.
No matter what the divorce decree says, if the non-custodial parent plans to use any of the children as exemptions, the custodial parent must give the non-custodial parent a signed release -- Form 8332 -- authorizing them to claim a child on their federal income taxes.
"The value of the dependency exemption could be worth up to a $3,700 tax exemption for each child," said Kate Byrne, a senior wealth planner at PNC Wealth Management, Downtown.
She suggests divorced parents agree to alternate years in which they claim the children. For instance, if there are three children, the father could claim two and the mother could claim one child during even years and vice versa during odd years.
Alimony and child support can be another bone of contention.
Child support is a non-deductible expense for the payer and non-taxable income for the recipient. Meanwhile, alimony is a tax deductible expense for the payer and is treated as taxable income for the recipient.
Michael Kelly, a Santa Monica, Calif.-based divorce law attorney with 40 years experience, suggests an alimony payment strategy that divorced couples can use to lessen or eliminate the tax burden on both parties.
"A lump sum payment for alimony can be maneuvered to make it non-taxable," Kelly said. "You can use the transfer of property, which also is non-taxable to the recipient and non-taxable to the payer.
Kelly said other assets that divorcing couples can manipulate in the same way to avoid taxes include 401(k)s, pensions and annuities.
"It can be a non-taxable event to transfer any of those assets," he said. "But you need a CPA to give you this advice to use any of these strategies."
(Reach Tim Grant at firstname.lastname@example.org.)
(Distributed by Scripps Howard News Service, www.scrippsnews.com.)
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