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Divorce & Taxes: Things You Need to Know

As we continue the push towards April 15, 2012 the WolfBridge Financial team plans to focus most of our blogging efforts around offering up information that hopefully will help tax day come and go much easier than it may have otherwise.

We recently stumbled on a very helpful article and video that can certainly be useful to those of you who may have gotten divorced in the last calendar year. So check out everything we have below and feel free to download our 3 minute podcast of Tax Tips for Divorced Couples.

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Divorce and Taxes: Five Things You Need to Know

Courtesy: Time.com

1. On Marriage Status, Go by the Calendar
Even if your divorce was finalized between Jan. 1 and April 18 this year, you are still officially hitched to your ex-spouse when it comes to filing your 2010 taxes. The flip side: if your divorce became official in December, you can’t file as married even if you were for most of the year and it would save you money. There is, however, a third status you can claim besides single or married. It’s called “head of household,” and it could save you money. The status was originally meant for single people, but some people in the middle of a divorce might qualify as well. To do so, you have to have lived apart from your spouse for the last six months of the tax year; paid over half the cost of keeping up your main residence; and be able to claim, under the rules for children of divorced or separated parents, your child as your dependent. Also, you have to file a separate tax return from your spouse, even if you are still legally married. But if you are still willing to fill out your estranged mate’s IRS forms, go ahead and check the married box. (See the top 10 celebrity relationship flameouts.)

2. Splitting the House May Be Harder Than Splitting Up
You don’t have to pay income taxes on assets that are transferred during a divorce. But if you end up getting the house, you won’t be getting it tax-free. The reason has to do with capital gains taxes, which still apply even to the recently divorced, and they come into play if you decide to get rid of your house after the divorce. Normally, a married couple doesn’t have to pay taxes on a gain of up to $500,000 on their primary residence. But now that you are single, you can only exempt half of that. So if your house sells for more than $250,000 more than what you and your former spouse paid for it, you will owe taxes. But you do get one advantage if you are recently divorced: if you moved out of the house before the divorce was final, and then ended up getting the house in the proceedings anyway, you can still claim the house as your primary residence.

3. Just Because the Kids Spend Time with You — Even Equal Time — Doesn’t Make Them Dependents
Years ago, the majority of custody arrangements were quite simple: the mother got custody of the children and, as a result, the right to call them dependents. In recent years, however, custody agreements have become quite creative and custody may be shared over weekends, vacations or during the workweek. These arrangements are complicated by the fact that neither the most recent version of the tax code nor IRS regulations define exactly what is the definition of custody or a custodial parent.

Generally, you can claim the kids as dependents only if you were designated the custodian by court order. When there is no such agreement or order, or when joint custody applies, the custodial parent is considered to be the parent who has physical custody of the child for most of the year. What happens when you share custody 50-50? Of course, you can’t both claim the same kid as a dependent. That’s against the law. Some couples switch who claims the kids from year to year in order to share the tax benefit, and if you only have one child that’s the only option. But if you have more than one kid, the best bet to avoid confusion may be to split the dependency of the kids up between the two parents, which is allowed even if both kids spend the same amount of time with each parent. (See an album of British weddings.)

4. Alimony Looks Good on Your Tax Return
In most cases, alimony, if you are the one paying it, will lower your tax bill. Even better, alimony is an above-the-line deduction, which means you don’t have to itemize to get the tax advantage. Still, there are no tax breaks for lingerers. If you and your ex-spouse continued to share a residence after the divorce, any alimony payments made during that time cannot be deducted. What’s more, the payments have to be pursuant to a written separation or divorce agreement, and cannot be considered child support. So couples who are facing extended divorce proceedings due to finances, custody battles or state laws that require extended periods of separation may still have trouble qualifying for the deduction.

5. Child Support Is Always Tax-Neutral
While alimony is considered a taxable event, child support is always tax-neutral, meaning it doesn’t affect your taxes in any way. This can provide an incentive to the ex-spouse who is making the payments to attempt to classify part of child-support payments as alimony, especially as state laws increasingly complicate the requirements for support. In recent years, for instance, parents have been required to make payments for college education. No matter how big the check — or how long a parent has to write it — the tax-neutral rules still apply.

Seven Financial Mistake You Can Make During Your Divorce

The seven worst financial mistakes you can make during your divorce.

1)  Making a major purchase - Perhaps a new house?  A new car?  These are purchases that may impact your situation negatively.  For example.  You are currently living in a $300,000 house.  You purchase a $200,000 house.  Keep in mind, that your combined income with you and your spouse paid for the $300,000 house.  You just added a significant expense.

2)  Selling highly appreciated stock for cash flow – Right now it might seem like a good idea.  You think, “I can always put this money back once things settle.  And I need the money now to pay attorneys and for cash flow”.  With a significant capital gain, and no losses to offset, your tax bill may be quite high.

3)  Not taking into account the tax implications of spousal support – So you’ve got an agreement in place, and your spouse is paying you alimony.  Your spouse gets to take those alimony payments as a reduction in his or her taxable income.  Guess what that means?  You now have to pay taxes on that income.  This can be especially troublesome if you haven’t planned correctly.  Make sure you account for this, either by setting up a separate account that will pay the taxes, or by adjusting your payroll deductions.

4)  You don’t withhold taxes from the 401k distribution - Ok, so you need some money to pay off bills (attorney, credit cards, etc.) that you accumulated during this process.  So when the time comes to receive a distribution from your spouse’s 401k, you cash out some (or ALL!) and do not have taxes withheld.  Once again, when Uncle Sam comes knocking, you will owe a large tax bill.

5)  Assuming “getting the house” is the best deal - You’ve all seen the tabloids and the newspapers looking at the high profile divorces.  People will say, “Well, she got the house, so she made out like a bandit”.  Unfortunately, not all assets are created equally.  The “house”, which in this case is the marital home, may be a money pit, may have negative equity (especially in this economy), or may just be too expensive for one spouse to maintain.  Make sure you consider all of the options, including selling the house, before you make this decision.

6)  Quitting your job so you don’t have to pay alimony – While this might seem like a good idea, all it is going to do is get you in trouble with your spouse and the courts.  You will still be required to pay alimony.  You don’t get a free pass here.  What this will do is make you look less sympathetic.

7)  Not planning – The biggest mistake you can make is not actually planning.  Divorce is a confusing time, and you often are not thinking rationally.  A good plan will prevent a lot of things from going awry and ruining your financial situation.  Stop, take a deep breath and consult someone who will help you to navigate the complex financial issues that are associated with your divorce.