Divorce and Taxes

“Timalyn, Alyssa and I filed for divorce, and we will finalize everything before Thanksgiving. Does this change things for our taxes?”

“No! Can we wait until January 1?” were my initial thoughts. But then I realized that if this news blindsided me, the seemingly happy couple was probably also scrambling for answers. They were looking to me to be calm during an upcoming storm.

To give you some context, I had helped this family lower their back taxes by $16,000 and get a payment plan that worked well with their cash flow. Then, by implementing a few strategies they had just saved an extra $20,000 on their last tax return. We were planning on saving them even more money in upcoming years.

Then, that is when it happened. Divorce.

I never saw this happening, so I never prepared for it. But if it happened to me, it will happen to you. Clients divorce.

Some of the things we are going over today may seem obvious to you. But remember what is obvious to us as tax experts is not obvious to our clients, especially if they are going through a life-changing event such as divorce.

Here are four things you need to inform your client about when it comes to their divorce and taxes.

Their New Filing Status

Someone always asks me a variation of this question every year. “Do we need/have to file this last year together since we stayed married the majority of the year?” The answer is no. It is not even an option. The IRS looks at the last day of the year^[1] to determine a taxpayer’s married or single filing status.

If the taxpayers divorce by or on December 31, the IRS considers them not married for that tax year. If there is no final divorce decree by then,  the IRS considers them married for the full year. There is an exception if the spouses lived separately the past six months of the year and have children. The filing status of the custodial parent may be head of household. The filing status determines a taxpayer’s new standard deduction and whether they can still claim certain credits.

The table below shows the standard deduction amounts for 2023.

An example of a deduction taxpayers may not claim after divorce is the student loan interest deduction. Over 45 million Americans have student loan debt. Modified adjusted gross income (MAGI) determines whether they can claim this deduction. If a couple has a MAGI of $144,999 or less, they can claim the full $2,500 deduction.

However, if spouse A has a MAGI of $90,000 and spouse B has a MAGI of $50,000, after the divorce, spouse A can no longer claim the student loan interest deduction. This is because the IRS phases the deduction out for single taxpayers once their MAGI reaches $70,000.

When we add children to the equation things can get a little spicier.

If ex-spouse A, Ashton, claims the baby taxpayer and provides more than half of the baby taxpayer’s support, their filing status will be head of household. That is a straightforward example. There are instances where your client may claim their child, but their filing status still is single. You can see from the table above that Ashton can deduct an extra $7,050 of their income vs. a single individual.

The filing status and claiming a child after divorce can have a big impact on your client’s tax situation. It will shift the amount of income that is taxable, even putting them in a new tax bracket. Let’s look at the 2023 tax brackets below.

Their New Tax Bracket

New tax brackets are not always a good thing for both taxpayers after divorce. Not only can they potentially lose the ability to claim certain credits and deductions. They may also have to pay taxes at a higher rate. This often catches taxpayers by surprise, especially if they divorce toward the end of the tax year. The U.S. tax system currently has seven different tax brackets for individuals. They are 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.

Taxpayers enter these brackets at different levels based on their tax filing status. For example, a single taxpayer in 2023 enters the 24 percent tax bracket once their taxable income reaches $95,375. Taxpayers married filing jointly don’t enter the 24 percent tax bracket until their taxable income reaches $190,750. You can see from this example that single taxpayers may get hit a little harder at tax time. The table below shows 2023 married filing jointly tax brackets.

Rev Proc 2022-38

If we have a couple with a combined taxable income of $175,000, divorce in 2023, their individual tax brackets will differ. Together, they were in the 22 percent tax bracket. Let’s assume that spouse Y has a taxable income of $150,000 and spouse Z has taxable income of $25,000. When they divorce, assuming they can claim the same deductions, spouse Y now goes up to the 24 percent tax bracket. Spouse Z goes down to the 12 percent tax bracket.

Not only that, but taxpayer Y also has more of their income taxed at a higher rate. See the 2023 single taxpayer table below.

Rev Proc 2022-38

Spouse Y needs your help immediately! Prior to the divorce, the IRS was taxing their income above $89,450 at 22 percent. Now that they are single, the IRS starts taxing their income at 22 percent at $44,725 and their income above $95,375 goes to 24 percent. One of the first things you can do to help them is to help adjust their withholding and estimated tax payments. The next thing is to schedule them for a tax planning consultation.

“Splitting Everything 50/50”

“They’re going to take half of everything I worked hard for!”

Have you heard this before? There are some things that the couple will split 50/50 but for tax purposes that’s not always how it works. One thing they cannot split is you. A practitioner cannot represent a client before the IRS if there is a conflict of interest^[2]. This includes limited and unlimited representation. It goes on to spell out an example of this conflict is when representation to one or more clients is materially limited by the practitioner’s responsibilities to another client.

You have a duty to let them know there is a conflict. There is a waiver the clients can sign to give you their consent to represent them. However, I do not recommend it. That way no one can question your ethics in the situation. You will have to tell one or both spouses goodbye as clients.

 Let’s look at an example of how a conflict can arise with estimated tax payments and capital loss carryforwards.

The IRS will treat capital loss carryforwards the same as net operating losses^[3]. The IRS allocates the loss to the spouse whose loss or deduction created it.

For example, Jenny and Mark divorced in 2023 and had a capital loss from 2022 of $20,000. The loss is from Jenny liquidating an investment account. Because the account was Jenny’s, she’s the one who can use the remaining loss on her tax returns.

The IRS allows spouses to allocate joint estimated tax payments. The taxpayers can choose how to do this allocation. If they cannot agree on an allocation, the IRS allocates the payments based on their prorated share of their combined separate liabilities.

Let’s look at Jenny and Mark again. They made $24,000 in joint estimated tax payments for 2023 but cannot agree on an allocation. Jenny’s 2023 return will show a $7,800 tax liability with $12,000 withholding. Mark’s return shows an $18,200 tax liability with $24,000 withholding.

Because Mark has 70 percent of the tax liability [18,200/(18,200+7,800)] the IRS will allocate 70 percent ($16,800) of the estimated tax payments to him. Jenny will receive the remaining 30 percent ($7,200).

Property Settlement

There is no gain or loss recognized on transfers between spouses^[4]. This includes transfers between former spouses if it is incident to the divorce. The IRS considers it an incident if it is within one year of the marriage ending or related to its ending. A transfer related to the end of the marriage is one made in a divorce decree and occurs within six years of the marriage ending or related to its ending. This applies to these different types of property:

• Real;
• Personal;
• Tangible;
• Intangible;
• Separate;
• Community.

The qualified retirement plan benefits of a participant are usually safe from assignment and subject to an early withdrawal penalty. But an exception applies if the benefits are under a Qualified Domestic Relations Order (QDRO)^[5]. A QDRO is a judgment that establishes an alternate payee’s right to the benefits. A spouse, former spouse, or child can receive the benefits.

There is no early withdrawal penalty when covered under a QDRO, no matter the age of the beneficiary. If the plan participant withdraws the funds and then transfers them to their former spouse, the distribution is taxable to the participant. It is also subject to the early withdrawal penalty of 10 percent if they are not 59½ yet.

Summary

Divorce waters are tricky to navigate. You have an opportunity to be a blessing to your clients while guiding them through the tax portion of it. The way the IRS treats the division of assets and adjusting to a different tax bracket will be new to your client. Take the opportunity to embrace change and pivot your tax plan. The spouse that stays with you as a client will appreciate it.