The tax treatment of your divorce settlement isn’t a one-size-fits-all scenario. No two divorces are the same, and neither are their tax consequences. The tax bite largely depends on the type of settlement components involved. Whether it’s alimony, child support, or property division, each has its unique tax treatment that can significantly impact your financial planning.
Before 2018, alimony payments made by one spouse to another could be deducted from the payer’s income; they did not have to pay tax on it. With the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, that changed significantly.
For divorce agreements executed or modified after the end of the day on December 31, 2017, alimony payments are no longer tax-deductible for the person who pays them. Further, the person who receives the money is not expected to report it as taxable income.
This change cancels a tax break for the payer. It potentially makes alimony payments more expensive for the one obligated to pay. For the recipient, things look brighter. They do not have to worry about paying taxes on the alimony received.
It's important to note that this change only applies to divorce agreements executed or modified after December 31, 2017. If your divorce agreement was finalized before this date, the previous tax rules still apply.
Juanita and Alex divorced in 2014 after nearly two decades together. As part of their divorce settlement, Alex agreed to pay Juanita $4,000 per month in alimony.
Under the pre-TCJA rules, Alex, the payer, could deduct these alimony payments from his taxable income. On the other hand, Juanita, the recipient, had to include the alimony as taxable income.
Post-TCJA, their tax liabilities remain the same unless their settlement is modified.
Marina and Marcus finalized their divorce at the end of 2020 after just about 20 years of marriage. Marcus agreed to pay Marina $2,000 per month in alimony.
Under the new TCJA rules, Marcus can no longer deduct these payments from his taxable income. This means he bears the full brunt of the alimony payments. Marina, however, does not have to count the alimony as taxable income. This lets her effectively keep more of the alimony in her pocket each month.
Payer can deduct alimony payments on taxes
Payer cannot deduct alimony payments from taxable income
Recipient must include alimony payments as part of taxable income
Recipient does not include alimony payments in taxable income
As mentioned earlier, if your divorce agreement was executed or modified after December 31, 2017, alimony payments you receive from your ex-spouse are not considered taxable income. This means that you do not have to report alimony payments on your tax return, and you will not be taxed on the amount you receive.
However, if your divorce agreement was finalized before December 31, 2017, the alimony payments you receive are considered taxable income, and you must report them on your tax return. In this case, it's essential to keep accurate records of the payments received and consult with a tax professional to make sure you're reporting the income correctly.
In general, property transfers between spouses as part of a divorce settlement are not taxable events. This means if you’re transferring ownership of your house to your soon-to-be ex-spouse, the Internal Revenue Service (IRS) won’t come knocking.
According to the IRS, the transfer of property between spouses or former spouses incident to a divorce is not subject to income tax, gift tax, or capital gains tax. This tax-free treatment applies whether the property is transferred directly or through a trust, and it must be completed within six years after the date the marriage ends.
While the transfer itself is not taxable, you may find yourself facing taxes when you eventually sell the property. The basis for determining capital gains or losses on the sale of the property remains the same as it was when you jointly owned the property. This means the cost basis – the original value of an asset for tax purposes – of the transferred property doesn’t get a fresh start when it changes hands in a divorce.
If your ex-spouse originally bought the property for $200,000 and it’s worth $350,000 when you receive it, the cost basis remains $200,000. So, if you decide to sell the property in a few years for $400,000, your capital gains won’t be calculated based on the value of the property when you received it but instead, on the original cost basis.
Capital gains tax is the tax you’ll pay when you sell a property you’ve acquired through a divorce settlement and it has increased in value. The tax isn’t levied on the total sale price but rather the increase, or the gain. This is calculated by taking the sale price and subtracting the original cost basis, which is the value of the property when it was first acquired, not when it was transferred to you in divorce.
Minimizing capital gains taxes following a divorce requires careful planning and consideration of various factors. Here are a few strategies to help reduce your potential capital gains tax liability.
If the property being transferred is your primary home, you may qualify for a capital gains tax exclusion when you sell the home. For single taxpayers, $250,000 or less of capital gains can be excluded. For married taxpayers filing jointly, that amount is $500,000.
To qualify for this exclusion, you must have lived at the address in question for two out of the five years before the sale.
Capital losses – when you sell an investment or property for less than what you paid for it – can offset capital gains on a dollar-for-dollar basis. This strategy, known as tax-loss harvesting, can help reduce your overall capital gains tax liability.
It’s important to note that you can use capital losses to offset capital gains, but if your losses exceed your gains, you can only deduct $3,000 per year against other kinds of income.
Capital gains tax only applies when you sell an asset. So, if possible, you could simply hold on to the property. If you don’t need to liquidate the asset right now, consider renting it out or using it for another purpose. Over time, the property may even increase in value more, adding additional value to your portfolio.
If the property being transferred is an investment property, you may be able to defer capital gains taxes through a 1031 exchange. This involves selling the property and using the proceeds to purchase a new, "like-kind" investment property. The IRS limits its use to vacation properties, and only rarely does it apply to a former principal residence. Specific rules and timelines apply to this process, so it's crucial to consult a tax professional.
At Hello Divorce, we do more than offer affordable online divorce plans and services like attorney advice and mediation. To support you through the financial complexities of divorce, we also offer CDFA sessions with a Certified Divorce Financial Analyst, access to divorce coaching, and resources about post-divorce budgeting. Our goal is. to keep divorce accessible and affordable for everyone.
