In the course of a marital dissolution, spouses may divvy up their financial assets. Some may take the form of property settlements, which are tax-free events, or alimony, which is taxable to the recipient and deductible by the payer. Unfortunately, it’s not always clear how certain property transfers or payments should be treated.
If one spouse earns income but gives it to the other pursuant to a marital agreement or court order, who is taxed on it? For example, when income earned by one spouse is collected by the other, who is taxed on it?
Retirement plan benefits
A spouse may be required to give some or all of his/her retirement accounts to the other party. If the transfer is done correctly, even though the spouse with the accounts had earned the income, the other spouse pays taxes on it when distributions from the accounts are taken.
In the course of a split up, the marital residence may be sold, or one spouse may continue to reside there. He or she may continue to share ownership or receive full ownership under the terms of a property settlement. The transfer of the home between spouses is a tax-free property settlement.
When the home is sold, the home sale exclusion may be available, permitting $250,000 of gain to be tax free ($500,000 on a joint return). For purposes of the home sale exclusion, which requires the seller to own and use the home as his/her principal residence for two of the five years preceding the date of sale, consider the following in the case of divorce:
Even though a payment by one spouse to the other is not a property settlement, it may not necessarily qualify for alimony treatment. In order to be deductible by the payer and taxable to the recipient, all of the following conditions must be met:
If, for example, payments can continue to be made after the death of the recipient, then alimony treatment does not apply. This means the payer has simply made a nondeductible payment; the recipient does not have to include it in income.
Anyone going through a marital dissolution should get tax advice about the financial details. Don’t assume that a family law attorney handling the legal end to the marriage is knowledgeable in tax law.