Don't Let Divorce Destroy You at Tax Time

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Divorce is one of the hardest things you may ever go through -- both emotionally and financially. But while you're focused on your now-adversarial relationship with your ex, you shouldn't forget to keep an eye on another entity that may be after a larger chunk of your assets thanks to your split: The IRS. Turns out, divorce has a huge impact on your taxes, and knowing what's at stake can help you avoid major complications later on.

Here are some of the things to keep in mind as you go through the divorce process.

Filing Status

Checking the box for either married or single may seem like the simplest thing in the world, but it gets complicated with divorce. The IRS wants to know your legal marital status as of the end of the year you're filing for. So even if you've filed your paperwork, if your divorce isn't final by Dec. 31, then you'll be considered married for the year.

However, there's an exception that allows separated parents to claim the favorable head of household status, which gives you greater deductions. To qualify, you must have paid more than half your housing costs for the year, lived apart from your spouse during the last six months of the tax year, and your dependent child must have lived in your home for more than half the year.

Exemptions for Children

The question of who gets to claim exemptions for children can make a huge difference to your tax bill. Typically, the test depends on which parent the child lives with for more than half the year. But divorced or separated couples can essentially pick who gets the exemption for children by signing a written declaration. With the current write-off at $3,700 per child, the decision you make can determine which of you will get up to $1,300 in tax savings.

Alimony, Maintenance, and Child Support

Payments between former spouses under a divorce decree fall into different categories. Cash payments that qualify as alimony are deductible by the person who makes them and are counted as income for the person who receives them. But you can generally agree to reverse that treatment and avoid any tax consequences for payments if you prefer.

Child support, on the other hand, isn't deductible by the payer or counted as income by the recipient or the child. So as you describe certain payments in your divorce agreement, be careful because the description can change the way those payments get taxed.

Retirement Accounts

As part of a property settlement, a spouse may be entitled to part of the other spouse's IRAs or employer-sponsored retirement account. For 401(k)s and other employer plans, a qualified domestic relations order can allow you to get benefits from a spouse's plan and treat them as if they're your own, thereby avoiding potentially disastrous tax consequences. Under certain circumstances, you may be able to roll 401(k) money into an IRA of your own.

Property Transfers

In general, neither spouse will realize any capital gain or loss or other tax consequences from receiving or giving up property in a divorce decree. But if you later sell property that you received due to divorce, you'll then have to pay taxes on gains, based on the original tax basis of the property you received.

To be treated as part of the divorce, a property transfer must be complete within a year of the date the marriage legally ended, unless it was specifically provided for under the divorce agreement. In that case, you have up to six years to make transfers, although later ones may still be valid if you can show valid reasons for the delay.

Community Property

Finally, most states treat each spouse's income as his or her own, even when it's jointly reported on a tax return. But in community property states, which include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, different rules may apply. As a result, you may be treated as having earned part of your former spouse's income during the year in which you divorce.

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Don't Let Divorce Destroy You at Tax Time

Many celebrities have gotten smacked down for failing to paying taxes. Wesley Snipes actually landed in prison for his $17 million unpaid tax bill, while Nicolas Cage owed a seven-figure amount to the IRS. A host of others, including Lindsay Lohan, Pamela Anderson, and Christina Ricci, have faced liens or tax bills for more modest -- yet still sizable -- sums.

The two main reasons for us ordinary folks getting stuck with a big tax bill are that your paycheck withholding needs changing or that you have outside income that comes without having taxes withheld. In either case, even if you can't afford to pay when the bill comes due, ignoring the problem will eventually land you in an even bigger heap of trouble. Instead, take advantage of IRS programs that let you make affordable installment payments over time.

Part of what put Wesley Snipes behind bars was his conviction on three counts of failing to file tax returns by their filing date. In part, he relied on a bogus theory that all income taxes are unconstitutional as justification for his actions.

But a much more common problem many people run into is that they can't afford to pay their tax bill right away. The mistake they often make is to assume that they shouldn't file a return at all if they can't pay. In reality, the penalties for not filing your taxes are much more severe than if you file but can't pay your taxes all at once. So even if you don't have the money to send with your return, go ahead and file. It'll save you a ton of money -- and possibly jail time -- in the long run.

AccountingWEB recently took a look at some of the great swag that celebrities received at the Academy Awards. With sponsors handing out goodies including everything from jewelry to exotic safaris, the gift packages added up to as much as $75,000 in value. But the recipients have to report it all as taxable income.

You may never be so lucky, but even more modest prizes often get reported to the IRS. If you get a Form 1099 reporting the value of something you received as a prize or award, not including it on your tax form could trigger a red flag at the IRS.

One allegation that Nicolas Cage raised regarding his tax problems was that his business manager mishandled his funds and caused big losses that destroyed his finances. Similarly, Martin Scorsese and Al Pacino both blamed convicted adviser Kenneth Starr for their tax woes. Starr went to prison for fraud and theft from clients.

Still, no matter where you go or how much you spend for tax preparation, you bear final responsibility for making sure your tax returns are accurate. Reputable accountants will reimburse you for any penalties and interest that result from mistakes they make, but don't count on them. Instead, make sure you understand the positions your tax pro takes so that you can defend them if a question arises.

As you look at the hijinks of your favorite celebrities, be sure not to make the same tax mistakes they made. With a little common sense and some planning, you can learn from celebrity mishaps the easy way.

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The problem here is that you may have no idea how much money your former spouse made. Accordingly, the IRS won't penalize you for mistakenly leaving out community property income as long as you can show that you had no reason to know about the income and that it wouldn't be fair to force you to include it as your own income.

Learn More

As you'd expect, there are all sorts of nuances beyond these general rules. Fortunately, the IRS makes it easy to get more information about the tax impact of divorce and separation. Just click here and see everything the IRS has to say on the subject.


Motley Fool contributor Dan Caplinger hopes you'll never need to use this advice. You can follow him on Twitter here.

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