Separating couples must deal with a multitude of issues, including child custody, child support, spousal support and division of marital property and debt. Among the issues relating to the payment of money or transfer of property, some items are taxable and some are not. Taxation issues are frequently taken into consideration by parties and attorneys in structuring a divorce settlement.
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Under current law, child support is untaxable, and the recipient neither pays tax on it nor lists it on her return. On the payer's side, he pays it out of his after-tax paycheck and cannot list it on his tax return. This is true no matter how much money he pays in child support or how little the recipient contributes to the support of the child in question. While parties are free to trade the child dependency credit and exemptions from year to year, child support is never taxable to the recipient or deductible to the payer.
Property and Debt Division
Like child support, amounts paid or property transferred pursuant to a divorce settlement is nontaxable. The idea here is that the parties accumulated the property with after-tax dollars and each already owns an interest in the property anyway. A critical part of a divorce settlement, whether one's jurisdiction is a community property or equitable distribution state, is properly characterising the transfer of property or money as incident to property division as opposed to spousal support. Vague settlement agreements can cause problems with the state and federal revenue authorities, and can also lead to disagreements between the parties as to what a transfer of funds or property actually represents.
Post-separation support and alimony are considered taxable income under current law. This means the recipient is required to report such support payments on her personal return and the payer is permitted to deduct them on his. The taxability of spousal support payments is one reason to be especially careful in drafting any divorce settlement document, as the characterisation of a given payment of spousal support, child support or property division can have important tax consequences.
The Role of Taxes In Settling a Case
While taxes are generally considered a burden by everyone, they can be useful tools in reaching a divorce settlement. Characterising payments as child support or part of a distributive award in property division allows parties to sidestep the emotional sting of paying alimony to a former spouse whom they feel may not deserve it. Moreover, such characterisation enables the payer to make a lower payment to the recipient without reducing her net benefit from the payment, as it avoids taxes. Also, the operation of different tax brackets may create a situation in which an alimony payer can deduct himself out of a higher tax bracket and into a lower one without kicking the recipient into a higher bracket. In this way, a party can essentially get his alimony obligation at least partially subsidised by the government and also gain concessions by the recipient elsewhere in the settlement.
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