Is Divorce Settlement Money Taxable?

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Selling a house after divorce

Divorce is difficult enough on its own, but figuring out the tax implications makes it even more complicated.

A divorce requires the division of all marital assets, from property to retirement savings. While sorting out which spouse will end up with what assets is the primary focus of divorce proceedings, it is also important to consider how taxes may affect each individual.

Learn how support payments, housing, and retirement accounts can impact your financials during a divorce.

Support Payments

Alimony

Alimony payments affect both parties, assuming the payments and amounts are established in the divorce settlement papers.

For the receiver, they’re a form of income, and must be reported on an annual tax return. For the payee, the alimony payments count as a tax deduction.

Child Support

Unlike alimony, receivers do not report child support as income, and the payee does not receive a tax deduction.

Additionally, when a divorce involves children, only one parent will be able to claim a child as a dependent. While this is usually easily established as the primary custodial parent, it can become more complicated when shared or joint custody occurs.

In this situation, the parent where the child resides for the majority of the year will be the one entitled to utilize the $1,000 child tax exemption.

House Matters

Property Transfers

Transferring property to your spouse in the event of a divorce will not result in a capital gain or gift tax liability for either party.

Courts consider this transfer to be part of the divorce, even if it takes place several years afterwards. When the transfer occurs within one year or the divorce, it is considered an incident to a divorce. If the transfer is completed within six years of the divorce, it will be deemed related to the marriage cessation.

Selling Your Home

If you decide to sell your home during a divorce, you may be entitled to a write-off. For those still filing jointly, you can claim a write-off of up to $500,000; those who are filing singly can write-off up to $250,000 from your federal tax.

To qualify for this write-off, you will be required to meet the three qualifying prerequisites.

  • Ownership Test – To be eligible, you will have to have owned the property for a minimum of two years during the five years leading up to the sale date.
  • Use Test – The user test requires proof that the home was used as a primary residence for at least a two-year period during the five years leading up to the sale date.
  • Joint-Filer Test – If trying to obtain the $500,000 tax benefit for filing jointly, only one of the filers will have to pass the ownership test, but both will be required to pass the use test.

In some divorces, the home may be retained by one of the spouses for a certain length of time before it is sold. This can result in the spouse failing the use test for many divorces.

In order to still gain the tax benefit when the house is finally sold, the parties can add additional language to the divorce papers that stipulate the other spouse can reside in the home until sold. Once sold, the proceeds are split accordingly. Having this additional verbiage may still allow you to write off the sale amount when the house is eventually sold.

Retirement Account Assets

In the event of a divorce, a settlement may require that part of a 401K retirement plan be paid to the spouse. However, it is important to exercise care when determining how to pay the settlement out of the 401k so you don’t end up paying distribution taxes.

It is possible to avoid paying distribution taxes by transferring money to your spouse via a qualified domestic relations order (QDRO). This order will allow your ex-spouse access to the funds in the 401k while preventing a distribution charge.

If you are going through divorce proceedings and would like more information about how taxes can impact your divorce settlement, contact the financial professionals at BP Financial today to schedule a consultation.

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