New England Tax

Alimony is the term used for payments to a separated or ex-spouse as part of a divorce or separation agreement. The payments are taxable to the recipient and deductible by the payer but are not treated as alimony if the spouses file a joint return with each other. Since 1985, two ways of defining alimony have been in effect, one for payments under decrees and agreements dated after 1984 and another for payments under decrees and agreements made before 1985. This article deals with only decrees and agreements after 1984 that applies to new decrees and agreements.

The following applies to alimony payments:

• Must be in cash, paid to the spouse, ex-spouse or a third party on behalf of a spouse or ex-spouse; 
  
  
• Must be required by a decree or instrument incident to divorce, a written separation agreement, or a support decree;
  
  
• Cannot be designated as child support; 
  
  
• Is valid alimony only if the taxpayers live apart after the decree. Spouses who share the same household can't qualify for alimony deductions. This is true even if the spouses live separately within the dwelling unit.
  
  
• Must end on the death of the payee; 
  
  
• Cannot be contingent on the status of a child (that is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony).

Payments need not be for support of the ex-spouse or based on the marital relationship. They can even be payments for property rights as long as they meet the above requirements. Payments need not be periodic, but there are dollar limits and "recapture" provisions. Even if payments meet all the alimony requirements, the couple may designate in their agreement or decree that the payments are not alimony and that designation will be valid for tax purposes.

The recipient of alimony must include it in income for tax purposes. The payee is allowed to deduct the payments as an adjustment to gross income. The payee must also include both the name and social security number of the recipient that the IRS uses with the income reported by the recipient.

Generally, a taxpayer’s home mortgage interest is limited to the interest on acquisition debt and $100,000 of equity debt. In a divorce action sometimes one spouse will buy out the other. Often in these situations, the buying spouse will incur additional debt to buy out the other spouse. The IRS in notice 88-74 has stated that in this situation, the additional debt, secured by the home, to buy out other spouse will be treated as acquisition debt.

In community property states, community income must be divided between spouses as required by state law. In general, community income is that earned while spouses live together. Married taxpayers domiciled in the following states are subject to community property rules: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

Local law determines the definition of when a spouse begins receiving separate income. California law, for example, says separate income begins from the date of separation.

Community Property Rules Disregarded - Community property rules won't apply to an item of community income, and a taxpayer has responsibility to report it if:

(A) The taxpayer treats the item as if only he/she was entitled to it, AND

(B) The taxpayer doesn't let his/her spouse know the nature and amount of the income by the extended due date of the tax return in question.

A taxpayer won't be held responsible for reporting an item of community income if all of the following apply:

(1) The taxpayer doesn't file a joint return,

(2) No item of community income is included on the separate return,

(3) The taxpayer didn't know of the community income, and

(4) Based on the circumstances, it wouldn't be fair for the taxpayer to include the community income on his/her return.

A Qualified Domestic Relations Order (QDRO) is a judgment, decree, or order relating to payment of child support, alimony, or marital property rights to a spouse, former spouse, child or other dependent. 

DISTRIBUTIONS: When it involves the allocation of the benefits of a qualified pension plan, the order has to contain certain specific information like the amount of the participant's benefits to be paid to each alternate payee. 

• Child or dependent - If a child or dependent receives a distribution under a QDRO, the amount is taxed to the plan participant.
  
  
• Spouse or former spouse - If a spouse or former spouse receives retirement benefits from a participant's plan under a QDRO, the former must report the payments just as though he/she were the plan participant. The taxability is computed by allocating the spouse/former spouse a share of the investment in the contract and figuring the taxable portion accordingly. 

ROLLOVERS: An alternate payee spouse under a "qualified domestic relations order" can qualify to rollover retirement plan distributions. The maximum amount, which may be transferred to another plan in a rollover, can't exceed the fair market value of all the cash or property received LESS any after-tax employee contributions, which are part of the distribution. Generally, a rollover must be completed within 60 days after a distribution is received in order to ensure non-taxability. 

The advantages of rollovers are that:

• They postpone the payment of tax until the funds are withdrawn from the new plan; 
  
  
• They provide a taxpayer with the opportunity of being in a lower tax bracket when the funds are withdrawn from the rollover account; 
  
  
• Funds can continue to accumulate in the new plan on a tax-free basis.

The disadvantages of rollovers are that:

• Amounts can't generally be withdrawn prior to age 59 1/2 without penalty;
  
  
• If the rollover was into an IRA, withdrawals are ordinary income and don't get the benefit of the 10-year averaging if the taxpayer qualifies.

EARLY WITHDRAWAL PENALTY: Generally, distributions from qualified retirement plans before the age of 59 ½ are subject to the early withdrawal penalty. However, distributions from a qualified retirement plan to an alternate payee under a qualified domestic relations order is exempt from that penalty. This exception does not apply to IRA accounts.

CAUTION: If the recipient rolls the distribution into his or her own IRA account, then any subsequent distribution will be subject to the early withdrawal penalty.

Who is deemed to have paid qualified tuition? IRS regulations provide that solely for education credit purposes, if a third party (someone other than the taxpayer, the taxpayer's spouse, or a claimed dependent) makes a payment directly to an eligible educational institution for a student's qualified tuition and related expenses, the student would be treated as receiving the payment from the third party, and, in turn, paying the qualified tuition and related expenses. In turn, qualified tuition and related expenses paid by a student would be treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer. 

Example: If one divorced parent pays qualified tuition to a college for a child, but the other parent has custody of the child (and is eligible to claim the child as a dependent), the custodial parent is treated as having paid the tuition directly to the college and gets the education credits, not the other parent. 

The regulations also provide that if a taxpayer is eligible to, but does not claim a student as a dependent, only the student can claim the education credit for the student's qualified tuition and related expenses.

Filing status for a tax year is determined on the last day of the tax year. If the taxpayers are married on the last day of the tax year (including those taxpayers in the process of divorce), then they have the following filing alternatives: 

• Married Filing Separately - This status is used when married taxpayers do not wish to file jointly. There are a number of punitive
  tax issues associated with married taxpayers filing separately.
  
  These laws were written to prevent married taxpayers from filing separate returns to take advantage of certain situations. The
  following are some of the commonly encountered issues:
  
  o To prevent one taxpayer from filing with itemized deductions and the other taking the standard deduction, the tax law requires both
  taxpayers to either itemize their deductions or take the standard deduction. Generally, if either itemizes their deductions, then both
  must itemize even if the deductions are less than the standard.
  
  o To prevent taxpayers from splitting their income and reducing it below the taxable income threshold for Social Security, the threshold for married separate taxpayers is zero. Normally, for joint filing taxpayers, the threshold is $32,000.
  
  o Passive income losses on a joint return are limited to $25,000, and that limitation is ratably reduced to zero between $100,000 and $150,000 of income. To keep married taxpayers from filing married separate to get around the income limitation, the deduction limit is cut in half and the phase-out occurs between $50,000 and $100,000.
  
  The government has addressed and eliminated most tax benefits derived from filing separately for married individuals. So, if you are considering such a move, be sure to discuss the possible ramifications with this office before proceeding.
  
  


• Married Filing Jointly - Married taxpayers, even if only one spouse had income, may file jointly. Once a joint return has been filed, the joint filers may not change to filing separate returns after the unextended due date of the tax return (generally April 15th of the following year). However, a taxpayer may file a joint amended return after filing married separate, if the change is made within THREE YEARS from the unextended due date of the original return.
  
  


• Head Of Household - Married individuals may use this status to file individually if they:
  
  (a) Lived apart from their spouse at least the last six months of the year,
  
  (b) Maintained a home for themselves and their dependent child or stepchild for more than half the year (nondependent child qualifies only if taxpayer gave written consent to allow the dependency to the noncustodial parent, or the noncustodial parent has the right to claim the dependency under a pre-'85 divorce agreement), and 
  
  (c) Paid more than half the cost of that home.

When married taxpayers file jointly, they become jointly AND INDIVIDUALLY responsible (often referred to as "jointly and severally liable") for the tax and interest or penalty due on their returns. This is true even if they later divorce. 

Joint filers remain "jointly and severally liable" even if a divorce decree states that a former spouse is responsible for any amounts due on previously filed joint returns. One spouse may be held responsible for all the tax due, even if the other spouse earned all the income. However, a spouse may be relieved of responsibility for tax, interest, and penalties on a joint return under special relief rules. Recent tax law changes make it easier for a taxpayer to qualify relief.

Tax liability relief for joint filers - Under changes that apply to tax liabilities arising after July 22, 1998 (and liabilities arising before that but unpaid as of that date), a spouse can be relieved of tax, interest, and penalties on a joint tax return. The request is made on Form 8857. Three types of relief are available:

• Innocent spouse relief
• Separation of liability
• Equitable relief

Innocent Spouse Relief - A taxpayer must meet all of these conditions to qualify for innocent spouse relief:

• Must have filed joint return with an "understatement" of "erroneous items" of his/her spouse;
• Must establish that at the time the taxpayer signed the joint return, he/she didn't know (and had no reason to know) that there was an understatement of tax;
• Taking into account all the facts and circumstances, it would be unfair (i.e., inequitable) to hold taxpayer liable for the understatement of tax.

Injured Spouse Relief - If a taxpayer's spouse has not paid child or spousal support payments or certain federal debts (e.g., student loans), the refund on a joint return may be used to pay the past-due amount, even though the debt arose prior to marriage to the present spouse. An injured spouse may be able to get his/her share of any refund, however. A person qualifies as an injured spouse under the following circumstances:

• He/she is not required to pay the past-due amount;
• He/she received and reported income on the joint return;
• He/she made and reported tax payments (estimated payments or withholding) on the joint return.

An injured spouse can get his/her portion of a joint return by filing Form 8379, Injured Spouse Claim and Allocation. Note: Taxpayers residing in community property states must divide refunds according to local law. If a taxpayer lives in a community property state in which all community property is subject to the debts of either spouse, the entire joint refund is subject to offset. Claims from California, Idaho, Louisiana, and Texas will usually result in no refund for an injured spouse.

The above is an overview of very complicated provisions of the tax law. Qualifying and filing for relief under these provisions requires the assistance of a professional. If you believe you qualify or have further questions, please contact this office.

Medical expenses paid for dependents may be deducted. To claim these expenses, the person must have been a dependent either at the time the medical services were provided or at the time the expenses were paid.

If either parent can claim a child as a dependent under the rules for divorced or separated parents, each parent can include the medical expenses he or she pays for the child. This is true even if the other parent claims the exemption for the child.

Often, when a couple separates and divorces, one spouse continues to live in the family home. Frequently, the departing spouse will simply quitclaim the property to the spouse retaining the home. When filed, the quitclaim deed takes the departing spouse's name off the title. However, it does not remove that spouse's name from the mortgage. 

So if you quitclaim a property to your spouse and he/she is late with payments, it will hurt your credit rating. To make matters worse, there is no way for you to get your name removed from the loan. Frequently, divorce attorneys fail to consider this adverse consequence. It may be in your best interest to require that the home be sold, or that your spouse refinance it as part of the divorce agreement.

No gain or loss is recognized when property is transferred between spouses during marriage. This rule applies also to transfers between former spouses if "incident to a divorce." A transfer is considered incident to divorce if it occurs within one year after a marriage ends, or is related to the ending of a marriage (i.e., occurs within 6 years after a marriage ends and the transfer is made under a divorce or separation agreement). A transfer that occurs later than 6 years after a marriage ends can be considered incident to divorce if the taxpayer can show that legal factors prevented earlier transfer of the property.

The basis of the property received in a transfer between spouses or former spouses is the adjusted basis the transferring spouse had in the property. In effect, the recipient spouse has received a gift of the transferred property. If that asset is later sold for a taxable gain, the recipient taxpayer will be liable for the entire gain. This is an often-overlooked ramification of a transfer. As an example, the taxpayer has a bank account worth $10,000 and stock worth $10,000 that was originally acquired for $4,000. If one spouse took the $10,000 bank account and the other the stock, that would not be an equal split since the one that took the stock would be responsible for the taxes on the $6,000 gain in the stock.

This is why it is so important to understand the tax implications associated with divisions and transfer of property incident to divorce. If this office can be of assistance, please call.

Tax rules include some special provisions pertaining to the transfer or disposition of the taxpayers' home incident to divorce and the application of ownership and use rules for purposes of qualifying the exclusion of gain. 

• Transfers between spouses or transfers related to divorce -
  For an individual holding property transferred between spouses or transfers incident to divorce, the period the individual owns the property includes the period the transferor owned the property. However, the period that the transferor spouse or former spouse used the property is not included in the period that the individual used the property. Therefore, the transferee spouse would still have to satisfy the use requirement in order to qualify for the exclusion.
  
  
• Sale after ex-spouse retains property for some period of time - Only for purposes of the home sale exclusion, an individual is treated as using property as the individual's principal residence during any period of ownership, while the individual's spouse or former spouse is granted use of the property under a divorce or separation instrument. This means that if a husband (or wife) continues to own the home after a divorce, and his/her former wife (husband) is granted use of the property under a divorce instrument, the exclusion could be available when the husband (wife) sells the house, if he (she) meets the ownership requirement and his wife (her husband) meets the use requirements.
  

The support test for children of divorced parents is based on special rules that are effective for 1985 and after. They apply if the parents together provide more than 50% of support, the child is in the custody of the parent(s) over half of the year, and the parents are divorced or legally separated under a written agreement, or lived apart at least the last six months of the year. 

BASIC RULE: The basic rule is that the parent with custody for the greater part of the year claims the dependent. 

EXCEPTIONS: However, the noncustodial parent can claim the exemption if: 

(A) The custodial parent signs a statement assigning the dependency to the other parent. The noncustodial parent then must attach the statement to his/her tax return. IRS Form 8332 is used for this purpose. The exemption release can cover a single year, a number of specific years, or all future years. The Form 8332 release is irrevocable, so exercise caution when using it. If there is any doubt, contact this office before signing the release.

(B) The child's dependency exemption is determined under a multiple support agreement. A multiple support agreement is one where a group of taxpayers provide the dependent's support and agree among themselves who is to claim the dependency. There are additional qualifications so please call this office for assistance.

(C) A pre-'85 divorce decree or qualified written agreement gives the dependency to the noncustodial parent, and he/she paid at least $600 for the child's support during the year. However, even if an agreement of this kind is in effect, the parents can choose to adopt the post-1984 rules.